The Accounting Onion

A Sampling of What Lurks at the Bottom of the Goodwill Garbage Heap

I have already reported stumbling upon a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one struck me right in one of my biggest pet peeves:

"In the process of recording ... [a business combination transaction] ... they discovered, by golly, that in a $300,000,000 acquisition, $100,000,000 of assets they thought they had didn't exist. And so the company tromped in with their auditors and said, the rules say the difference between what we got and what we paid is goodwill. I simply wasn't able to accept the fact that there should be $100,000,000 goodwill on their books, which didn't exist, and we told them to write it off."

I have explained in a previous post many months ago why I think the process of measuring goodwill and periodically testing it for impairment is a shameful waste of time and money. I would be hard pressed to think of a better example than Clarence's story to back that up. But, I also want to explain why Clarence's story is more than merely an interesting anomaly.

Goodwill (I despise the term, but will use it here for the sake of clarity and with the understanding that it's meaning as a term of art bears no relation whatsoever to what regular folks think it means) arises from two sources. One source is genuine assets that have been acquired, but for various and sundry good reasons those assets are never separately recognized under GAAP. Even the management that bought those assets probably can't adequately explain to you what those assets actually are in anything but very general and vague terms. Yet, in a business combination, we recognize them all together (and mixing them in with liabilities of a similar ilk as part of the process) as 'goodwill.'

The second source of goodwill are 'mistakes.' In other words, paying a price to acquire a company greater than its value. Although the amounts of money in Clarence's story are extreme, the fact of the matter is that mistakes happen all the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down after they have proudly announced their plans to acquire another company. During my part-time career as litigation consultant, I can recall at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or those assets were worth less than they were represented to be worth by acquirees. In all of those cases I was involved in, how did a mistake get accounted for? Capitalized as goodwill, of course! No Clarence Sampson or auditor suggested they do otherwise.

I suppose that one could justify initial capitalization of mistakes as goodwill, because they are impossible to detect at the time a transaction takes place; if they could have been detected, then the purchase price presumably would have been adjusted. But, don't business combination accounting rules give one a full year to adjust the values of assets acquired and liabilities assumed? Sometimes they do, but the rules don't mention that mistakes aren't supposed to go to goodwill; so that's where they go.

But, won't impairment testing eventually catch the mistakes and chase them out of goodwill? Not usually. If it ever should happen that a mistake pops out as an impairment charge, it's usually years after the mistake has become known to management. The goodwill impairment tests allow companies to aggregate subsidiaries into 'reporting units,' which are usually large enough to allow any mistakes to be offset by goodwill from other acquisitions that have accumulated a successful enough track record over time to protect their own goodwill, plus the goodwill generated by any recent mistakes.

At least the big mistakes will get caught by the Chief Accountant, right? Ironically, I doubt whether the current chief accountant or his predecessor would have the gumption Clarence did to stand up to a registrant and its auditor like that. Unlike Clarence, who spent decades coming up through the ranks of the SEC, these guys spent their distinguished careers chest bumping their fellow Big Four partners. When an erstwhile comrade-in-arms "tromps" into the SEC as his client's Doberman Pincer, will he be welcome with the secret Big Four handshake? But to be fair, today's SEC staff may not have the technical ammunition Clarence did; the FASB's sausage factory has created a new line of business combinations rules; their literal application has come to be the generally accepted method for leveling the M&A playing field…

… as opposed to Clarence Sampson's application of common sense principles:

"And that's the kind of thing that the Commission can say - look that's just too far; you can't look at the written words and try to apply them to a situation where it just doesn't make sense. And as a matter of fact there's some language, and I'll bet you can tell me where it is, which says if it doesn't make sense, you can't do it."

Those "written words" (principles-based rules?) Clarence couldn't specifically recall are still in the cupboard (see Exchange Act Rule 12b-20, and AICPA Ethics Rule 203-1), but they haven't been taken off the shelf in a real long time.

Anyway, I hope you enjoyed Clarence's story as much as I did.

Ten Reasons Against Mark-to-Market for Loans – and the Reasons Why They are Wrong (Part 2 of 2)

Continuing my previous post, here's reasons 6 – 10 with my responses.

6. There are also hedge accounting considerations. Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief. Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

Inflation is a real risk, and it is independent of management's free choice in their accounting for that investment. Ironically, the risk of greater-than-expected inflation is greatest in the presence of such a pledge to hold to maturity, yet through existing hedge accounting rules management is discouraged from entering into a hedge to reduce the risk of excess inflation on the purchasing power of its future cash inflows. This is because the gains and losses on the hedging instrument would actually increase the volatility of accounting earnings, while the effect of the hedge would be to reduce the volatility of economic earnings!

If all investments in debt instruments were marked-to-market, then management would choose the economic hedge that best fits the circumstances of the enterprise; they could choose to hedge default risk, inflation risk, prepayment risk, or whatever other risk that concerns them without worrying about silly rules regarding arcane accounting definitions for "macro hedging," "hedge effectiveness," documentation requirements and more. Management would also not feel a push one way or the other toward a particular brand of "hedging instrument."

7. The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory. Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem.

Actually, agency costs can occur because one party, usually the agent, is able to observe economic earnings (and take for itself an undeserved share of those earnings) because the principal cannot measure economic earnings as precisely and completely as the agent. Thus, accounting rules that deliberately distort economic earnings create agency costs, and not vice versa.

Exhibit A for the case that historical cost is the real purveyor of agency costs is the thankfully defunct SFAS 76 and related literature on accounting for an "in-substance defeasance" of debt. Basically, managers wanted to report gains upon early retirement of their bonds, which of course were measured at historic proceeds instead of being marked to market. (Obviously, the yield to maturity of those bonds had increased subsequent to issuance for whatever reason.) Those managers were prevented, either practically or contractually, in many circumstances, from retiring those bonds.

So, special interests did whatever they needed to do to get the FASB to permit in-substance defeasance accounting even if the bonds were not actually retired. The process was pretty straightforward: if enough dough were transferred into essentially riskless, irrevocable trusts whose funds could only be used to make payments to the bondholders, management could get their gain accounting upon funding the trust.

The economics, however, effectively transferred wealth from shareholders to bondholders for no other apparent reason, except to juice reported earnings. Essentially, the bondholders received a windfall gain, because their risky bonds on which they were earning a risk premium, all of a sudden were backed by a fully funded, risk-free trust account. In other words, they were still earning a risk premium without being exposed to any risk! Of course, after the FASB rescinded SFAS 76 et. al., the in-substance defeasance game became a lot less interesting.

My point is that agency costs are minimized when accounting reports economic income. Management can use the opportunity to report fictitious earnings to screw anyone they can: bondholders, employees, shareholders, whomever. Other examples include retiree healthcare costs (mentioned earlier) and compensation via stock options. In all of the cases I can think of when bad accounting became less bad, abuses lessened significantly.

8. We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.

It is quite possible that this "purchase contract" could become a derivative within the scope of FAS 133, and thus measured at fair value, if net cash settlement were required or permitted on each delivery date, instead of physical delivery of paper. In other words, it is currently required (and noncontroversial) to report "fiction" for complex derivatives, but not for other complex (and even less complex) debt instruments, or lease contracts, or purchase contracts, etc.

I am not proposing that we abandon FAS 133's requirements to measure complex derivatives at a current value, but rather to say that if we can tolerate "fiction" for derivatives, I'd like to know why we shouldn't tolerate it for other contracts.

Furthermore, I can only conjecture that the two parties to this transaction would not have entered into it, or at least modified it significantly if it actually did fall within the scope of FAS 133 or some other requirement to measure it at current values. Maybe, instead of Regis providing Dow Jones insurance that the price of paper won't go to high, a more appropriate arrangement would be made with a properly funded financial institution.

The only way to fix this sort of agency problem is to require current valuation of all legal obligations to make future deliveries of goods or services. I know it sounds drastic, but I believe it's necessary, and at least in the arena of lease contracts, the FASB is finally acknowledging that ignoring such contracts by calling them "operating leases" has benefitted only management and its "financial consultants."

9. Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted. One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.

Again, my response to the valuation problem of the debtor/obligor is to mirror the replacement cost measurement exercise of its counterparty.

10. Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees --- that's the ultimate loss.

Actually, on an aggregate basis, I am not sure that clients are actually paying audit fees even today. Each year, the increase in the Big Four's liability exposure (including interest) may be outstripping the fees that they are supposedly earning with audits that do little more than provide legal cover for corporate executives to lay claim to as much of the shareholders' money as they can get away with. Shareholder suits are threatening to bankrupt every single one of the Big Four, and ironically, a more stable (albeit less lucrative) future for audit firms can be found in mark-to-market accounting. This may be a stretch, but I read a wonderful quote of Upton Sinclair (courtesy of Paul Krugman) just today: "It is difficult to get a man to understand something when his salary [or, Krugman adds, his campaign contributions] depends upon his not understanding it."

Even in the absence of a change in measurement attribute, the SEC needs to radically think about the kind of assurance services auditors should be providing on financial statements. As just one example, what is the quantum of investor protection that is added when an auditor documents in its workpapers that the management of Bank XYZ has made an estimate of its loan loss reserves that "appears reasonable"? In place of a rubber stamp from auditors who, despite what any law might provide, can be fired by management virtually at will, I would prefer to be furnished with an independent appraisal of the replacement cost of the loan portfolio, prepared without the involvement of management. Auditors should go back to what they most often do well: count cash: test calculations; confirm receivables, payables, debt amounts and inventory counts; and little else.

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That's all, folks. Here's hoping that whatever the outcome of the debate on loan valuation, it will consist of more than pure politics. As the anecdote from Clarence Sampson indicates, capital markets regulators have been pushing for improvements to bank accounting for ages, with improvements being grudgingly conceded in decades-spaced drips and drabs. Now, finally, the FASB is aiming higher. Let's see whether they can score a hit somewhere in the vicinity of the bulls eye.

Beyond the "Inactive Markets" Problem: The Crisis in Accounting

"It's painful now to read a lecture that Mr. [Lawrence] Summers [who is currently President Obama's principle economic adviser as chair of the NEC] gave in early 2000, as the economic crisis of the 1990s was winding down. Discussing the causes of that crisis, Mr. Summers pointed to things that the crisis countries lacked — and that, by implication, the United States had. These things included "well-capitalized and supervised banks" and reliable, transparent corporate accounting. Oh well."

Paul Krugman, New York Times, March 29, 2009 [emphasis supplied}

"Oh well," indeed. It seems that NYU economist Nouriel Roubini has been given the lion's share of the credit for prognosticating the economic calamity we now find ourselves in. But many independent-minded accountants have warned, decades before Roubini, that our financial reporting standards – not just those rules having to do with mark-to-market – are as thin and flimsy as the paper they are printed on. That nobody would heed the warnings can only be due to the collective weight of the business and banking lobbies pressing on standard setters, with the paid support of the Big 8, 7, 6, 5, 4.   

Contrary to those with whom I usually stand on financial reporting issues, I am not going to excoriate the FASB for its latest kluges to GAAP, which they made at the behest of Congress.  Methinks that a few little tweaks to make banks look sounder was better than at least one other alternative: doing nothing. Who can argue that a 20% run-up in bank stocks isn't something that the economy needed RIGHT NOW?

My own frustration and sense of gloom is from two sources.  First, next-to-know-nothing-about-accounting congressmen may be further emboldened to hunt for messengers to shoot instead of focusing on real problems.  Second, as Krugman points out, financial reporting has been exposed as totally kaput, and it ain't getting fixed any time soon.  The question policy makers should be addressing is not whether we should keep GAAP or adopt IFRS, but rather how long it will take for both the FASB and IASB to become completely discredited as agents of investor protection.

Accounting Needs to Start with a Clean Sheet of Paper

Everyone agrees that there is no silver bullet that can fix the economy. Whatever the capitalist or socialist ideologues will preach, we can't simply scrap the current system and make a new one; every policy decision has to be made at the margin.

But, when it comes to financial accounting and regulation of financial institutions, I believe that 76 years after the enactment of the first federal securities laws, establishing the accounting and auditing disciplines as we know them today, it's high time to start over.

First, we have to start by completing de-linking those banking regulations from the rules of financial accounting. Second, we need to recognize that neither historic cost accounting nor fair value accounting are providing the answers we need. The second point is where I am going for the rest of this post.

The Choices: Fiction-, Fantasy- or Fact-Based Accounting?

The three candidates competing to be the foundation of accounting standards are historic cost, fair value, or replacement cost: stated another way, the choices are fiction, fantasy, or fact. By that characterization, I suppose you can already guess which of the three I would choose.

Historic Cost Accounting as Fiction

The conventional wisdom is that historic cost accounting is fact-based, objective and verifiable. The sad truth is that it is a fiction, however it has been practiced.

To account for historic costs, we subjectively choose which portion of a particular cost should be capitalized; and consequently, which portion should be expensed immediately.  Of the capitalized costs, we have to decide on a plan for transferring them to the income statement.  There can be no right answers, and there is hardly a pretense of impartiality in the numbers that management presents for the auditors to bless as "reasonable."

But even setting aside concerns of bias, so-called "historic cost accounting" only pretends to measure the historic cost of, say PP&E. Instead, fragments of historic costs are dumped in a parking place, bearing the fictitious name PP&E on a financial statement, fictitiously and pompously titled the "statement of financial position."  So, cutting through the pretense, historic cost accounting is simply a rules-based protocol for describing past cash flows and selected 'expected' future cash flows. Big deal.   

Proponents of historic cost, defend it as "verifiable," but as the example of PP&E illustrates, net book values are not verifiable; neither is the allowance for doubtful accounts verifiable, or any other estimate management makes.  The term "verify" stems from "truth", and there is nothing true about these numbers other than the unavoidable fact that management made them up.  

And the auditors?  We derive little value, if any, from an audit report that opines on "reasonableness" of the estimates that make up those fictitious book values.   Walter Schuetze, former FASB board member and SEC Chief Accountant (where he was my boss) gave a zinger of a speech in 2003 on this topic a few years ago to the New York State Society of CPAs. Among other things, he proposed a much more limited role for auditors (and an expanded role for other independent appraisers).  To my mind, the speech is Roubini-esque – so disquieting that the accounting profession and its regulators could respond only by acting as if one of the most visible and prominent accountants in the world did not make it.  If I were teaching an accounting theory class or auditing today, I would spend at least two sessions discussing its implications.  You can access it here.

Fair Value as Fantasy

Fair value, sometimes referred to as mark-to-market or exit value accounting, consists of a series of predictions of the outcomes of liquidating transactions that probably won't occur.  Some people like exit values, especially for gauging the health of financial institutions, because the values assigned to assets provide some indication of margin of safety in the reporting entity's financial structure, should liquidations be required to pay off creditors.

But the sturm und drang of the past few years in implemting SFAS 157 should be some indication that fair value has some real problems -- if not as a principle, then at least in its implementation.  I think it's both.

The fundamental problem with an exit value approach is the need to imagine the market conditions that would exist at the time of the hypothetical liquidation. Therein lies the fantasy; the Pollyanna FASB wants preparers to assume that liquidation won't happen under duress, but the reality is that unplanned liquidations happen under duress more often than not.  Not only that, whatever the market conditions that are to be imagined do nothing more or less than replace the market conditions that actually did exist around the time of the balance sheet date. 

To clarify the implications of fair value, let's momentarily step away from financial assets, and consider a very simple scenario (inspired by an unnamed source, who claims that it is based on fact):

A Ford dealership in rural Vermont has an inventory of 300 model F150 pickup trucks. The dealer sold about 50 - 60 trucks a month in 2006 and 2007.  In 2008, the dealer sold 30 trucks all year, with only 10 from July through December.  In January 2009, the dealer had one sale.  In February 2009, the dealer had no sales.  In March 2009, the dealer has had no sales.  What is the fair value of the 300 trucks in the dealer's inventory? 

Zero, or something close, would be a simple answer that everyone can understand, but most would consider useless as information relevant to assessing the present financial position and future prospects of the dealership. But, under these circumstances, no higher amount could be legitimately described as an 'exit value,'  simply because anything other than a recent price is a made-up number.   

Seeking fair value is just as problematic for subprime mortgages as it is for those pickup trucks. That's because, as I just stated, the question of 'fair value' or 'exit value' is nonsensical when there are no currently active markets for either trucks or subprime mortgages. Valuing a subprime mortgage by the discounted cash flows to be derived from holding it does not magically change a 'value in use' to an 'exit value,' even if the parameters to the DCF model are based on so-called 'marketplace assumptions.'  When we rely on management to estimate the sales price that would clear out the inventory of pickup trucks, or to estimate default rates and discount rates for subprime mortgages, that's fantasy and not fair value. Even worse, we are back to where we started with historic costs: biased estimates buttressed by audits of, to be kind, questionable value.

Replacement Cost as Fact

Every western economist, from Paul Krugman to Gary Becker, accepts as axiomatic the notion that wealth is manifested by the command over goods and services. For a non-cash asset, the appropriate measure of its wealth effect is the amount it would cost to replace it (let's leave aside the question of obsolete assets for the moment).

In a nutshell, if you think accounting is about reporting financial margin of safety, then fair value is for you. And by "you," I mean primarily the bank regulators. But if financial accounting is supposed to be about reporting wealth and changes in wealth to investors, then you gotta go with replacement costs.

Replacement cost accounting is fact-based. It accounts for the wealth you now have. It's not about what you hypothetically could have if, in some imagined scenario, you suddenly  sold an asset for its 'fair' price, whatever that means. Replacement cost accounting is most certainly not about fantasizing that you can command a nice price for an asset from selling it in a market that may not, and in many cases does not, actually exist. Replacement cost accounting is much simpler and, dare I say, saner: it measures actual wealth and actual changes in wealth – isn't that what we were taught accounting is supposed to be about?

Of course, measuring the replacement cost of what you have is subject to error, just as is any other measurement. Getting back to trucks, how does replacement cost accounting handle the absence of a market in which to sell an asset? Perhaps not easily, but a heckuva lot easier than FAS 157, or any other implementation of exit value accounting could. The Ford dealer still knows almost exactly how much he would have to pay to buy 300 trucks, even if every single Ford dealer in New England were feeling the heavy breathing of lenders on the backs of their necks. Nevertheless, the price would be a lot higher than zero; and, that's because the trucks are still worth a substantial amount of money. As for the subprime mortgages, even though there haven't been a lot of recent transactions, dealers and other holders should have a pretty good idea (indepdent of management) of how much it would take others to part with their holdings.

I prefer fact-based reporting of wealth to fantasies of exit value. In both of the new proposed FSPs, the FASB has invoked the SEC's recent study on fair value accounting. That study has also recommended that replacement cost should be given a closer look.

When the FASB takes time from responding to the congressional command to chase its own tail, perhaps we can take out that clean sheet of paper and write accounting rules that are based on fact, instead of fiction or fantasy. I'll be honest, I don't know if it can be done, but I think it can; and we won't know until someone tries. 

Toward a New Big Eight: A Deal The Big Fours Can’t Refuse

Jim Peterson, who blogs on the auditing profession, has written an excellent summary and analysis of the failure of the U.S. Treasury's Advisory Committee on the Audit Profession to recommend a solution to the Big Fours' exposure to liabilities threatening their solvency. By the way, Re:Balance is worth reading simply out of appreciation for Jim's elegant writing style. Also, check out his funky bow tie!

"Did anyone really think that the endless chatter about saving the system of privately-provided audits for large global companies would come to anything? ...
...those sincerely believing in the importance of large-company assurance are avoiding an election between two unappealing choices: Either put every effort to assure that the Big Four are insulated from the very catastrophic risks that the critics insist they must remain exposed to, or start the process of designing the new audit model that must arise after the collapse of the Big Four under the abdication of the Treasury Committee and its counterparts."

I agree with Jim that the current audit model is broken: the notion of independence is fatally flawed, and much of what passes for auditing does not create useful information for investors. Ironically, the "services" that merely provide a perfunctory rubber stamp on management's judgments may create their most significant exposures to liability. Walter Schuetze, former SEC Chief Accountant and FASB member, explained this much better than I can in a 2003 speech to the New York State Society of CPAs. The deafening silence in response to his challenge to make audits simpler and more relevant attests to the fact that political will to fight deeply entrenched interests in the current system is virtually non-existent.

But, I do not agree with Jim's characterization of the Treasury Committee's winding up as an "abdication." Knowing personally and by reputation some of the committee members, like Lynn Turner, Don Nicolaisen and Gary Previts, I would be skeptical that a good faith effort to effect real change was absent. And perhaps, the Committee has unwittingly set the stage for real change by confirming what may have already seemed obvious to many: the absence of economic incentives for the Big Four to compromise.

So, where Jim sees two alternatives, I see a third. If we can all agree that government regulators bear some responsibility for the precarious position of being exposed to a disaster should one of the Big Four goes under – they should have put the kibosh on at least two of the three big mergers when they had the chance – then other solution paths will have been opened. For example, the government could offer to share the litigation exposure from each of the Big Four’s prior audit engagements in exchange for splitting up into two completely separate firms.

The immediate effect of such an offer is that the audit firms will be presented with a "prisoner’s dilemma." They will perforce separately conclude that their best chance of riding out the storm is to cut the ropes that lashed them to the other three lifeboats. If the offer to share costs is generous enough, I’m betting we can have a New Big Eight within a year. While this may not completely obviate the need to reform the audit model, which might take another catastropher to catalyze, at least some progress will have been made.   

The cost sharing I am suggesting in exchange for a New Big Eight (apologies to BDO and Grant Thornton) could also reduce litigation costs: legitimate plaintiffs won't be stonewalled because losing a case will no longer result in a firm's demise. And the audit firms would now be able to afford to take claims of less merit to court, thereby discouraging future claims. 

There may be other lasting and significant benefits of a New Big Eight as well.  First, risks of further litigation could actually be reduced if the new firms act to exercise tighter controls. Second, audit fees could be reduced by competition, with related incentives to innovate and become more efficient.

Would there be any diseconomies of scale from split ups of the Big Four? I don't know, but I surmise nothing drastic would happen. There may be some redundancies in the need to maintain technical staffs, but that could finally provide some real incentives to simplify accounting and auditing rules (maybe that’s wishful thinking). It is also possible that exposure to catastrophic litigation became higher as firms got bigger: operations were simply too decentralized to control effectively, and/or extra-deep pockets gave incentives for plaintiffs to ask for larger amounts of compensation for damages.

I'm already lusting over the prospect of christening the new mini-behemoths.  How about PriceWater and HouseCoopers? Would Mr. Young get his first name back on the firm he founded (Arthur, for those of you too young to remember) ? Would the other Ernst be resurrected? Enough already!

SEC Settlement with Auditors of WorldCom: Too Little, Too Late?

Coming on the heels of accusations that the SEC is trending toward less vigorous enforcement against financial reporting violations, the SEC published here and here its settlements with the two Arthur Andersen partners that planned and supervised the 2001 audit of WorldCom.  Six years later, the settlements amount to little more than slaps on the wrist:  both auditors were suspended from practicing before the SEC for at least three years, no monetary penalties were assessed, and no admissions of guilt were obtained.  (By the way, one of the auditors has let his CPA license lapse, and the other is still licensed as a CPA in Mississippi.)

I have three questions for the SEC.  First, why were these individuals allowed to settle without admitting or denying guilt in what appears to have been an open-and-shut case?  Second, why were no monetary penalties assessed?  Third, why did it take six years, with only this so-called "settlement" to show for all this time and, presumably, effort?

I'll leave any kind of thorough treatment of the last two questions for future ruminations (feel free to do it without me!), and will focus henceforth on my dissatisfaction with a settlement that does not require auditors to admit to the public that they made inexcusable mistakes -- in what was apparently a slam-dunk case. 

Background

Most readers will recall that the WorldCom accounting fraud was astonishing for both the magnitude of the errors in the financial statements, and the simplicity of the accounting.  We're not talkin' 'bout complex financial arrangements, arcane consolidation, pension, stock option or revenue recognition rules; we're talkin' the third week of Accounting 101.  We're talkin' about capitalizing telephone line access fees ("line costs") that should have been expensed.  Over a number of quarters, $3 billion in payments that should have been reported as expenses on the income statement were parked in property and equipment (P&E) accounts on the balance sheet.  The "top-side" accounting entries to effectuate the fraudulent misstatements circumvented internal controls and were made by accountants with the highest authority in the company.   

The $3 billion capitalization of line costs was the first of the WorldCom accounting frauds to come to light, but it paled in comparison to the additional $8 billion of accounting misstatements that were subsequently discovered.  As Cynthia Cooper, the whistle blower on the first $3 billion wrote in her recent book (I reviewed it here):

"...[top management at WorldCom] had a process called 'close the gap,' whereby they would compare quarterly revenue to Wall Street expectations, analyze potential items they could record to make up the difference, and book revenue items that had not been booked in the past."

Given the magnitude of the misstatements, it doesn't seem possible that they could have occurred in the absence of a broken audit.  The two Andersen partners on the WorldCom account were charged with violating the SEC's own rules of professional conduct as they apply to accountants* who practice before the Commission: Rule 102(e). That also should have kept things relatively simple, as the case would be made before an administrative law judge; no interaction with the courts or other government agencies would have been required.  I'm not a lawyer, but I think that the threshold standard of proof in such a case would have been the same as civil litigation, "preponderance of evidence."

Also, the SEC reached only for the low-hanging fruit when bringing their charges against the two audit partners, both of whom had been involved with WorldCom for a number of years.  Basically, in addition to intentional, knowing or reckless conduct, the most difficult to prove, there are two other ways that an accountant can violate Rule 102(e):

1. A single instance of highly unreasonable conduct that results in a violation of professional standards in circumstances in which the accountant should know that heightened scrutiny is warranted, or;
2. Repeated instances of (merely) unreasonable conduct, each resulting in a violation of professional standards that indicate a lack of competence.

The SEC wisely chose the second of these two.  All they wanted, and needed, to address was conduct in violation of the equivalent of the third week of Accounting 101, plus the third or fourth week of Auditing 101. At the risk of being tedious, but to educate my readers who are taking Auditing 101 and to make the point that the SEC must have had a slam-dunk case, here is but a sample of the SEC's allegations:

• Andersen discovered fraud of a similar nature a year earlier, and affecting the same PP&E accounts.  There were other strong indicators that fraud might occur, like the financial straits of the CEO, a history of aggressive accounting, and industry factors.  Consequently, the engagement team classified overall audit risk as "maximum."  However, substantive tests of PP&E , one of the most significant balance sheet categories, were not expanded.
• The auditor's did not design or implement procedures to review top-side entries, evidently relying on management's representation that there were no significant top-side entries--even though fraud via top-side entries took place just one year earlier. 
• Additions to the PP&E accounts were only examined through the third quarter of 2001, and not as of the end of the fiscal year.  $841 million of the fraudulent charges to PP&E occurred in the fourth quarter.
• A reconciliation of beginning and ending PP&E balances was not done.  If the auditors had done so, they would have discovered that the $3 billion in fraudulent charges to PP&E were made in circumvention of normal approval processes.
• The expense accounts that were reduced by the top side entries were not reconciled to the financial statements and general ledger.  "Had they done so, the auditors would have discovered that the line cost expenses they were testing were significantly larger than the line cost expenses reflected in WorldCom's financial statements and general ledger."

Back to the Question

Let's be generous, and presume that those who pull the levers at the SEC subjugate their personal interests for the public interest.  Indeed, one could argue that there have been many cases where the SEC obtained the same monetary fines and sanctions -- or maybe even more -- in a settled action than it could have gotten in court.  One of the reasons this may be the case is that many defendants have an economic disincentive to admit guilt in an SEC action.  That's because (once again, I'm not a lawyer) one who admits guilt to the government may not deny it in a private action -- where the money penalties could be much bigger. 

So, in many instances, it may actually serve the public interest to give defendants the option of settlement with the SEC without an admission of guilt; but, my point is that it is certainly not always the case.  Now, ceasing to presume motives as pure as the driven snow, the SEC counts scalps, and a settlement containing an agreement to be sanctioned, however meaningless, counts as a scalp to be hung up before Congress and the world.  Fewer settlements mean more trials, and more trials mean fewer scalps. Even considering the predisposition for scalps of any color, this case took six years just to get settled! And, how many defendants are coerced into settling without admitting or denying guilt just so the SEC can have their scalp, even though the accused parties truly feel they did nothing wrong, but need to get the matter put behind them? 

Focusing specifically on the case of the WorldCom auditors, I can't possibly see how the public interest was served by settling without a fine, and without an admission of guilt.  If there was ever a case where the SEC could have sent an unequivocal message by making its case in court, this one was it. Can anyone say that more was gained by settling? Given the magnitude of the numbers, timing and other circumstances, can anyone say that the public does not rightfully want to know whether and how WorldCom's auditors violated the basic standards of their profession? 

And, not only is there a message opportunity, the public deserves more justice and closure.  Will private litigation against these auditors take place?  I doubt it, because their pockets probably aren't deep enough to fund the private attorneys.  Therefore, the argument of a defendant loathe to settle because of exposure to private litigation goes poof. Will the AICPA or state accountancy boards discipline these auditors?  It's been six years, and so far not a peep from them either -- just one more reason we need the PCAOB.

For the SEC, it shouldn't be about the money they collect in fines, or the number of years of sanctions they obtain from settlement, or even (and this is, I admit, controversial) about the sheer number of cases they bring.  It should be about deterrence: the message sent by a case that will contribute to greater trust in the capital markets by reducing the risk of fraud.  The reality, though, is that it is very convenient and self-serving to measure and report monetary fines,** volume of cases and years barred from practicing before the Commission.  The flip side of this reality is that one cannot possibly measure how many frauds did not occur because of the threat of vigorous and consequential law enforcement. Ergo, the focus of bureaucrats on scalps; in the case of the 2001 WorldCom audit that misplaced focus results in giving unduly short shrift to deterrence.   

-----------
*Note to students: the SEC rules of professional conduct apply to all accountants at public companies -- not just their auditors.

**Well, maybe you can't always measure the effectiveness of the SEC by the fines they mete out. See Jonathan Weil's commentary in bloomberg.com on how he believes SEC Chair Cox inflated the numbers he reported in recent congressional testimony.

More on the CAQ Survey

I thought I had beaten flat the CAQ's survey of audit committee members in my last post.  Lo and behold, here is one more nasty tidbit brought to my attention that merits sunlight.

Among the organizations that with whom CAQ partnered for the recruitment of survey takers was the National Association of Corporate Directors (NACD).  NACD must know who among its members are on audit committees; nevertheless, it blithely sent CAQ's survey out as a mass mailing to all of its 17,500 members.  As you may well have anticipated, there were no controls to ensure that the survey would be responded to by audit committee members only.

OK, so maybe not all respondents were actually members of audit committees -- big deal. But, what if respondents weren't even members of a corporate board?  According to the NACD website:

"NACD accepts both individual and full board membership. Associate membership is available to professional services organizations -- such as legal practices, audit firms and compensation consultants -- who provide essential board guidance and advisory services." [italics supplied]

Recalling that CAQ based their statistics on the responses of only 253 volunteers, how many of these volunteers weren't even board members?   What if 50 of the respondents were actually audit partners?  My point is that they survey methodology was so loosey-goosey, we have no way of knowing. 

Gatekeepers Hoodwinking Gatekeepers

As Bejamin Disraeli said, "There are three kinds of lies: lies, damned lies, and statistics."  Perhaps statistics is the most insidious of the trio because they can be the most beguiling.  The CAQ sits at the same point on the Disraeli scale as any other lobbying organizations who conciously produce data that they intend to be mistaken for information.  But, there should be an important difference: the CAQ is controlled by audit firms who, according to the "P" in "CPA", purport to be ethically bound to protect the public interest.  When journalists are hoodwinked by CAQ into reporting on mere data as if it were information, then CPAs have failed to live up to the ethical standards of those who fund it.

Journalists also function in a large sense as gatekeepers for misleading information.  How ironic is it that CAQ, an organization funded and controlled by audit firms, was so facile in its manipulation of other gatekeepers?

Low Quality Stats from Center for Audit Quality

Much ado has been made lately of the insubstantial contribution business school professors have made to practice through research.  Accounting research of the last forty years, being no exception, was blasted in a commentary in the Chronicle for Higher Education for not addressing questions relevant to accounting professionals.  The authors, academic accountants themselves, blame universities for not providing more robust incentive systems to encourage a broader range of topics and methodologies. 

I want to add another reason:  practitioner organizations barely give lip service to academic research, because their members actually don't want to know what academics have to say.  That's because the truth can be so darn inconvenient (apologies to A. G.).  Just recently, the Financial Accounting Foundation says it doesn't believe it is necessary anymore to have academic representation on the FASB (see earlier post); and now a new report by the Center for Audit Quality (CAQ) presents the results of their "commissioned" survey of audit committee members.  "Research," by any standard academic, it ain't.

I have two problems with the survey.  First, the survey methods are so crude, that if an academic had tried to present this work to peers as serious research, either his sanity or intelligence would be called into question.  Second, the presentation of the "key findings," such as they are, have been skewed to fit the public relations agenda of the accounting profession:  post-Enron rehabilitation of auditors' reputations, and entrenchment of the revenue-producing aspects of SOX.  Other than these two criticisms, the report is just fine.

Let's start with the methodology:

Non-random sample -- CAQ states, without explanation, that it was "not feasible from a cost or time standpoint" to take a random sample.  How ironic is it that an organization sponsored by auditors would forgo random sampling, the indispensable basis of so many auditing standards, procedures and concepts?  CAQ blithely asks us to assume this is a minor detail:

"With a pure probability sample of this size, one could say with ninety-five percent confidence that the overall results would have a sampling error of +/- 6.2 percentage points.  As this survey is not a pure probability sample, theoretically no sampling error can be calculated."

Setting aside that calculation of a sampling error is not "theoretically" possible (read simply as "not possible in any way, shape or form"), +/- 6.2 percentage points is actually a pretty large number that can affect one's reading of the results.  Maybe that's why it is not mentioned again in the report.

Sample size -- Let's agree that the population of interest, audit committee members of public companies, number very approximately 10,000.  Only 253 of them volunteered in response to invitations to participate.  Given the low participation level, it is highly likely for non-respondents to have significantly different opinions than the self-selected volunteers.  If anything was done to test that proposition (yes, academics routinely apply techniques for doing so), CAQ did not report it.

Sample demographics -- CAQ gathered very little information about the respondents.  We know virtually nothing about their financial or accounting expertise.  For example, how many are "designated financial experts"?  How many are former auditors? 

We do know, however, that 44% took their first position on an audit committee post SOX.  As some of the key survey questions ask their opinions about the pre- and post- SOX environment, their opinions may be different, or even less reliable, than the respondents with longer tenure on audit committees.

Wording of the questions -- Let's say you joined your first audit committee in 2007.  How would you respond to this key question:

"Based on your experience as an audit committee member [italics supplied], how would you rate the overall quality of audits of publicly traded companies being conducted today?

First, I don't know if a respondent could reliably separate their audit committee member experience from their prior experience.  Second, given the variability in length of tenure of audit committee members -- some pre-SOX, and other not -- it appears as if two populations are being combined into one. 

The next survey question is:

"And over the past several years, would you say that the overall quality of audits of publicly traded companies has...?" 

Assuming that the "based on your experience" language carries forward, how is the newbie audit committee member supposed to answer that?  Dunno.  Remember, these folks are 44% of the respondents!

Integrity and Objectivity Red Flag -- Neither the organization that purportedly conducted the survey was disclosed in the survey report, nor the scope of their responsibilities.  Imagine an audit report not identifying the auditor; this is not much different.  Was the contractor a well-respected company that didn't want to be associated with the end product?  Was it an organization with other ties to CAQ?  Just asking.    

Now, on to the reported "key findings"

Current state of audit quality -- The audit committee now appoints the auditor and reviews their work much more closely than in the pre-SOX era.  What board member would be willing to admit, even anonymously, that their choice of auditor was a mistake?  So, it's not surprising that CAQ finds that 95% of respondents rate their auditors' work as "good" or better.  As a "key finding", it's a big fizzle. 

The other side of the coin is more provocative: a client paying top dollar for audit services should not be satisfied with work that was only "good" or "fair." That's how 22% of respondents saw it.  Moreover, 17% said that the situation had not changed or worsened since the passage of SOX. 

Risk of fraudulent financial statements -- CAQ blithely reports that 87% of respondents believe the risk of releasing financial statements that are materially inaccurate due to fraud is not very high.  That's a good thing?  I don't think so, especially when you consider that these are audited financial statements!  Has SOX affected the potential for fraudulent misstatements?  The CAQ would like you to think so, because auditors sure have made a lot of money out of ICFR audits.  Yet, unstated is the fact that 40% of respondents do not believe that the risk of fraudulent misstatement has decreased with SOX. 

Complexity of financial statements -- CAQ would like you to believe that audit committee members think that financial statements are too complicated.  But, the questions don't even begin to address the nature of the complexity, or the sophistication of the respondents as regards financial statements.  And if you still doubt that a self-serving agenda is driving the report, here's the smoking cannon: buried in the back pages (question 17C) is the undiscussed finding that respondents clearly do not feel that GAAP is too complex.  Yet financial statements are too complicated.  Figure that one out!

If you are one of those who believe that the CAQ was created by the powers that be to function as shill for audit firms, then this survey report could be your Exhibit A.  It is also Exhibit A for my point that practitioners with self-serving agendas have good reason to be threatened by the contribution of academics.  But, if truth is the goal, then the participation of academics, trained and paid to apply discipline and rigor to a question, is an asset. 

IFRS Chaos in France: The Incredible Case of Société Générale

"Breaking the Rules and Admitting It" is the title of Floyd Norris's column describing the accounting by Société Générale for the losses incurred by their rogue trader Jérôme Kerviel; the title is provocative enough, but it's still not adequate to describe this amazing story. Although I am reluctant to come off as a prudish American unfairly criticizing suave and sophisticated French norms, what Société and its auditors have perpetrated would be regarded here as the accounting equivalent of pornography.

I don't aim to re-write Norris's excellent column, who rightly asks what a case like this says about the prospects for IFRS adoption in the U.S.  But, I want to make two additional points.  To tee them up, here's an encapsulation of the sordid tale:

• Société Générale chose to lump Kerviel's 2008 trading losses in 2007's income statement, thus netting the losses of the later year with his gains of the previous year.  There is no disputing that the losses occurred in 2008, yet the company's position is that application of specific IFRS rules (very simply, marking derivatives to market) would, for reasons unstated, result in a failure of the financial statements to present a "true and fair view."      
• You might also be interested to know that the financial statements of French companies are opined on by not just one -- but two -- yes, two -- auditors.    Even by invoking the "true and fair" exception, Société Générale must still be in compliance with IFRS as both E&Y and D&T have concurred.  How could both auditors be wrong?  C'est imposible.   

The first point I want to make is that Société's motives to commit such transparent and ridiculous shenanigans are not clearly apparent from publicly available information.  My unsubstantiated hunch is that it has to do with executive compensation.  For example, could it be that 2007 bonuses have already been determined on same basis that did not have to include the trading losses (maybe based on stock price appreciation)?  Moreover, pushing the losses back to 2007 could have been the best way to clear the decks for 2008 bonuses, which could be based on reported earnings -- since the stock price has already tanked. 

The second point was made by Lynn Turner, former SEC Chief Accountant in a recent email.  The PCAOB and SEC are considering a policy of mutual recognition of audit firms whereby the PCAOB would promise not to inspect foreign auditors opining on financial statements filed with the SEC.  Instead, the U.S. investors would have to settle for the determination of foreign authorities.  Thus, if the French regulators saw nothing wrong with the actions of local auditors -- even operating under the imprimaturs of EY or D&T -- then the PCAOB could not say otherwise. 

Never mind the black eye the Société debacle gives IFRS, this sordid case must surely signal the SEC that mutual recognition would be a step too far; however, I'm not counting on the current SEC leadership to get the message. 

"Extraordinary Circumstances": Take it to the Beach

It may be an understatement to say that the general public is rarely engrossed by a story about the trials and tribulations of an accountant at work.  Time will tell whether "Extraordinary Circumstances" by Cynthia Cooper will be that rare case, but at least it has a chance.  Cooper was the leader of WorldCom's internal audit department that discovered the first $3 billion dollars in false accounting entries. 

I decided to read "Extraordinary Circumstances" because I wanted to learn  more about the major players at WorldCom, how the fraud was discovered, and how it was perpetrated.  I was also curious to learn how the story of a fraud that was so simple at its core could take more than 350 pages to tell. 

As it turns out, the story I was expecting could have easily been told in about one hundred pages; even the chapter titles indicated that it would take me at least 200 pages to get where I thought I actually wanted to begin.  But, as I was reading the book, impatient to get to the good stuff, I got hooked on the seeming mundaneness of how a smart -- but not brilliant, hardworking -- but not obsessed --teenager picked accounting as a career, got hired and fired, married, became a mother, divorced, and remarried to a stay-at-home Dad.  Much of this was skillfully interwoven with the history of WorldCom, along with the pathos of good corporate soldier accountants meeting their end, and the tragedy of telecommunications demigods going to any extreme to avoid experiencing the consequences of their own fallibility.

Ironically, the parts of the book that I expected to be best were actually a big fizzle.  I already knew before I started reading that accounting manipulations at WorldCom were multi-faceted.  To begin, there was the fraud discovered by Cooper: improper capitalization of period expenses to the tune of about $3 billion.  That, alone, would have set a record for an accounting manipulation.  But, an additional $8 billion would be discovered soon thereafter; and the reader has hardly a clue about where those cookie jar reserves came from, and how they were used in the fraud.  I suppose that's OK, because after the first layer of cream cheese, the second might be anticlimactic.  But I think Cooper missed, or barely mentioned, two other important elements that explicate the WorldCom culture leading up to the fraud.

The first element was the accounting for business combinations. As WorldCom grew through an aggressive acquisition strategy, rigging the accounting (a la Cendant) to ensure that each acquisition would be accretive to earnings per share from day one would be critical.  It must not have been very easy to manage the favorable accounting when some or all of the purchase price was paid for in WorldCom stock.  It also wouldn't have hurt to use the opportunities in business combination accounting to create cookie jar reserves in all sorts of accounts, but Cooper didn't even allude to any of this.   

The second element was that a company as reliant on Wall Street's favorable opinions as WorldCom was, must have been fiddling with their earnings for years.  Yet, it wasn't even mentioned until page 338:

"...Bernie and some of his top lieutenants had a process called 'close the gap,' whereby they would compare quarterly revenue to Wall Street expectations, analyze potential items they could record to make up the difference, and book revenue items that had not been booked in the past." 

I suspect that Cooper, as an internal auditor, may not have been aware of the practice, or even have recognized how insidious it is--and how interwoven it had become in corporate cultures prior to Enron, WorldCom, and ultimately Sarbanes-Oxley.

So, here's the bottom line.  Would I have paid $27.95 to read "Extraordinary Circumstances" if the publisher hadn't given me a free copy?  I doubt it.  But if you're looking for some light beach reading and tired of fiction ... wait for the paperback.

But, now that I own the book, I'm going to give it to my son to read.  He's a freshman in college and is thinking about majoring in accounting.  I'll be curious to know how much of the accounting and finance in the book he can understand, and more curious to know if he thinks that he could be a whistle blower like Cooper--if he were the one between a rock and a hard place.   

Blowing the Whistle on Cynthia Cooper

I'm now going to address an aspect of the book that many would see as minor, but I can't bring myself to let pass.  I was particularly put off by Cooper's thinly-veiled religious proselytizing -- along with her disingenuous assertions that Mississippi, where the story takes place, is unfairly tarred with a reputation for backwardness, racism and bigotry.  Maybe I'm overly sensitive to Pollyannas because my parents are Holocaust survivors, or maybe it's from my own experiences of late 20th century bible-belt style bigotry. 

Or, maybe it's because I remember that one of the more prominent bigots during the period Cooper writes about was Kirk Fordice, the two-term governor of Mississippi from 1992 - 2000.  Fordice wore a tie featuring a Confederate battle flag when he announced his opposition to a plan setting aside $4 million of state construction contracts for minority-owned firms. When the U.S. Supreme Court considered ordering the state to spend more money on its historically black colleges, Fordice suggested that he might call out the Mississippi National Guard rather than comply.

Fordice also made the claim that "the less we emphasize the Christian religion, the further we fall into the abyss of poor character and chaos in the United States of America." South Carolina governor Carroll Campbell quickly offered a correction, adding "Judeo-" as a prefix to Christian, but Fordice snapped back he meant what he said.   

Like Fordice, it seemed that every person Cooper was close to in Mississippi was a churchgoer and/or openly devout -- Bernie Ebbers said a prayer before each analysts' conference.  But, the fear of God didn't seem to deter the fraudfeasors; and this ineffability was passed over by Cooper, even though it is surely provocative and full of important moral lessons.  That would have made for more interesting reading than how the love of God helped the whistle blowers tolerate the pressures they were under.  When Cooper's doctor prescribed anti-depressants and time away from work, she would not reveal the name of the drug or its effect; but in the same paragraph thought it apropos to plug the bible-inspired self-help book she was reading while taking her medicine.

In any case, I'm one of those guys who believe that one's religious views should be a private matter.  But, I do admit wanting to know whether Cooper voted for Fordice.

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.