The Accounting Onion

Where is the Center for Audit Quality When We Actually Could Use It?

Below is an email I received from Lynn Turner. My several comments are in brackets, and the italics/bolding are all supplied by yours truly (I also took the liberty of fixing a couple of minor typos):

"One of the interesting side stories during the Congressional Debate on the IPO legislation [Jumpstart our Business (JOBS) Act, which I wrote about in my previous post] is the remarkable deafening silence of the Center for Audit Quality (CAQ) [which tries to brand itself as "nonpartisan" and "dedicated to enhancing investor confidence and public trust in the global capital markets" -- but behaves more like a joint venture of the Big Four and the AICPA] as the debate had moved to the Senate. While in the past they have been very vocal opposing legislation that would step on the independence of the FASB, and that would roll back the SOX requirement for companies to have their internal controls examined, there are no such letters forthcoming to the Senate this time.

I suspect it is because in the legislation, there are provisions that would limit the ability of the PCOAB to impose auditor rotation. In addition, the legislation would impose a new requirement on the SEC to conduct a cost benefit test of any new rule the PCAOB itself adopts, prior to the SEC approving the rule. This would apply to new rules the PCAOB has under consideration such as to expand what the auditor reports to investors, and efforts to enhance auditors' objectivity and independence through such means as auditor rotation. And the laws would require the SEC to do the analysis within 60 days of when the PCAOB adopts a new rule. This is an impossible task given court rulings in the last year on how the SEC must perform such analysis.

As such, this proposed law would likely make it most difficult for the PCAOB to adopt new rules, if the large[st seven] auditing firms [all of which are represented on the CAQ's governing board] opposed them. Already, I understand the CAQ has told reporters litigation would be forthcoming if the PCAOB adopted a standard for auditor rotation.

It appears as if the CAQ has finally shown its true colors. One must wonder if its independent board members agree with this approach as we have heard nothing publicly from them on this.

As to those (only three) "public" board members, let me get this part out of the way first: I am told by an anonymous source, who is plugged in enough to know about such things, that public board members receive around $100,000 in compensation for serving. Not that this arrangement explicitly buys silence in public on matters inimical to the interests of international auditing firms, but at least it is something that the CAQ should be more upfront about. I haven't found anything on the CAQ website to indicate how board members are recruited or compensated.

At a minimum, these "public" board members should be questioning the CAQ administration as to whether a lack of comment is a breach of commitment to CAQ'ss stated mission.  But, I'm going to take this one step further for one particular public board member, Harvey Goldschmid. He is a former SEC Commissioner and a long-time member of the law faculty at Columbia. I am unable to bring any direct evidence to bear on the question, but I do find it (more than) curious that, at the behest of CAQ, he has insinuated himself into the IFRS adoption discussion, yet he has kept his own counsel on the JOBS Act.   

As to IFRS, Mr. Goldschmid has chosen to be a strong proponent of IFRS adoption by the SEC in conferences sponsored by CAQ-allied entities. His message has been that the U.S. must adopt IFRS forthwith – or else face dire consequences. In doing so, he makes no apology or allowance for the fact that he is speaking outside of his field of expertise; he is not an acknowledged expert on accounting and auditing matters. I have also stated that I believe his rhetoric, made in tandem with the IASB chairperson (also not an auditing and accounting expert), were synthesized from an admixture of vague generalities, selective use of the facts, cherry picking of academic research, and biased speculations of a doomsday to come if the SEC does not act to adopt IFRS.

I'm not saying that every securities law professor has a civic or moral duty to make their views known on every proposed piece of capital markets regulation, but I do find it remarkable and ironic that Mr. Goldschmid chooses to speak freely about IFRS adoption, while choosing to keep his own counsel on topics that are right square in his wheelhouse: SEC registration requirements and exemptions.

Stated another way, I know of no other securities law professor who is advocating publicly for IFRS adoption except for Mr. Goldschmid; however, I do know that many prominent professors are highly circumspect or critical of the JOBS Act. Here's just three:

• John Coffee, Mr. Goldschmid's colleague at Columbia no less, has derisively nick-named the bill's crowd-funding provision the "boiler room legalization act." As to other provisions of the bill, he is not so impressed by those either.
  
• Harvard law professor John Coates finds it "odd" that "amid an economic downturn caused in part by financial deregulation … Congress should be actively considering (and indeed have passed in the House) a raft of proposal [sic] for more financial deregulation.
• If the views of other prominent academics in his field are not persuasive enough, then perhaps Mr. Goldschmid should consider the views of MIT Economist Simon Johnson, who has called the JOBS bill, "a colossal mistake of historic proportions" that won't create jobs and will raise the cost of capital instead.

Surely, for such a significant piece of capital markets regulation, an active and lauded former Commissioner would not want to miss an opportunity to weigh in along with his academic colleagues, wouldn't he?

Lynn is absolutely correct: if the CAQ were truly nonpartisan, as opposed to the equivalent of the National Rifle Association for international auditing firms, it would have issued a public comment on the JOBS Act – at least to the extent that it affects auditors and financial reporting. And, as Lynn strongly implies, the CAQ board should be called to account.  Moreover, if Harvey Goldschmid cares to be perceived as an independent thinker, as opposed to a hired gun, we should be hearing what he has to say about the JOBS Act as well.

The collective failure to speak out on the JOBS Act undermines CAQ and Mr. Goldschmid's credibility on every other issue for which he has supported CAQ; and most especially, IFRS adoption.

"Thinking Fast and Slow" about Auditing

My writings in this blog have focused on the absence of linkages between financial reporting and the economic concepts like wealth and value creation/destruction. But, accounting is more than applied economics. Individuals acquire accounting information before making decisions; and heuristics and biases affect the quality of those decisions. I spent much of my academic career thinking about these concepts, and Daniel Kahneman's new book, Thinking, Fast and Slow, brings me back to those halcyon days.

In that vein, I would like share with you this autobiographical vignette from Chapter 7, entitled "A Machine for Jumping to Conclusions":

Early in my career as a professor, I graded students' essay exams in the conventional way. I would pick up one test booklet at it time and read all the students' essays in immediate succession, grading them as I went. I would then compute the total and go on to the next student. I eventually noticed that my evaluations of the essays in each booklet were strikingly homogeneous. I began to suspect that my grading exhibited a halo effect [defined as the tendency to like (or dislike) everything about a person – including things you have not observed], and that the first question I scored had a disproportionate effect on the overall grade. The mechanism was simple: if I had given a high score to the first essay, I gave the student the benefit of the doubt whenever I encountered a vague or ambiguous statement later on. … I told the students that the two essays had equal weight, but that was not true: the first one had a much greater impact on the final grade than the second. This was unacceptable.

I adopted a new procedure. Instead of reading the booklets in sequence, I read and scored all the students' answers to the first question, then went on to the next one. I made sure to write all the scores on the inside back page of the booklet so that I would not be biased (even unconsciously) when I read the second essay. Soon after switching to the new method, I made a disconcerting observation: my confidence in my grading was now much lower than it had been. The reason was that I frequently experienced a discomfort that was new to me. When I was disappointed with a student's second essay and went into the back page of the booklet to enter a poor grade, I occasionally discovered that I had given a top grade to the same student's first essay. I also noted that I was tempted to reduce the discrepancy by changing the grade that I had not yet written down, and found it hard to follow the simple rule of never yielding to that temptation. …

… The consistency I had enjoyed earlier was spurious; it produced a feeling of cognitive ease and … [I] … was happy to lazily accept the final grade. By allowing myself to be strongly influenced by the first question in evaluating subsequent ones, I spared myself decisions of finding the same student doing very well on some questions and badly on others. The uncomfortable inconsistency that was revealed when I switched to the new procedure was real: it reflected both the inadequacy of any single question as a measure of what the student is and the unreliability of my own grading.

The procedure I adopted to tame the halo effect conforms to a general principle: decorrelate error! [pp. 83-84; italics supplied by me]

The lessons that any student or professor can take from the story are obvious and compelling; and grading happens in auditing, too – a lot.

Auditors Have Feelings, Too

The standards that form the foundation for the practice of auditing were laid down long before the study of heuristics and biases in decision making gained traction among psychologists, and eventually economists. But, while a revolution in psychology and behavioral economics has been taking place, the key driver of audit reliability shifted from objective verification to subjective "grading" of judgments made by management when preparing financial statements.

For example, auditor term limits can be regarded by behaviorists as an effort to mitigate serial errors as the auditor accumulates too many positive vibes from the client. The resistance to any any form of auditor firm term limits by auditing firms is effectively either: a denial that a confirmatory bias – as if auditors were inoculated from this human fallability; or perhaps like Kahneman's grading story, a statement that auditors have identified the problem and figured out a solution – much as Kahneman dealt with his exam grading issues.

But, neither argument seems valid. Delving a little deeper into auditing procedures, auditors 'grade' numerous judgments made by management. Yet, there are no explicit policies that I am aware of that have been instituted for decorrelating those grades. According to the confirmatory bias, order matters a great deal. Maybe, auditors should be making and documenting their judgments and estimates independently of management (and even without looking at prior years' work papers), before deciding whether or not a judgment by management "appears reasonable."

Or, perhaps, auditors will maintain that supervisory procedures within the firm ensure that judgments are unbiased and independent. But, that doesn't appear to be the case. Audit managers 'grade' numerous tasks performed by audit staff members, and it seems to me that little or nothing is much different about the way it is done than the way Kahneman performed his grading – until he realized something was amiss.

In the current environment, can it be said that standards governing "independence," "technical competence" and "sufficient evidence" are enough to produce reliable audits? The weight of evidence brought to bear by psychologists suggest that auditing judgments may not be reliable without instituting explicit procedures for decorrelating errors in auditors' judgments.

Kahneman's story is memorable for his self insight in recognizing a halo effect was influencing his own judgments, the creativity to devise a successful strategy for mitigating bias, and the discipline to implement a costly strategy. If only the accounting profession would recognize its duty to the public to strive to act in a similar fashion, we would all be wealthier and wiser.

It's Nice to Win Something, Even if it’s the "Losing Cause Man of the Year"

No one likes to be told they are irrelevant, but that was my first reaction to Bob Jensen's AECM post, in which he dubbed me the "Losing Cause Man of the Year." I am certain that Bob meant it as a compliment, and I've gotten over the unintentional slight. Now, I am ready to reflect on how I came to merit such a dubious distinction.

I'll begin by restating Bob's remarks. I am using much of his own words, but without quotation marks (the full text of his remarks are here).

Losing Cause 1 — Fending Off the Takeover (Convergence) of US GAAP by the International Accounting Standards Board

Tom has never accepted that international standards will replace domestic accounting standards in the United States. But, the takeover of US GAAP by the IASB is a fait accompli because all the people that count applaud such a takeover. Domestic corporations like the idea of softer principles-based international standards replacing the thousands of bright line hard rules in present U.S. GAAP. Multinational corporations really like the idea of only having one set of accounting standards to deal with year after year. Large auditing firms and the AICPA are salivating over being able to bill companies for IFRS training programs and materials and software.

The only serious, albeit ineffectual, resistance to IASB takeover of U.S. GAAP has been perpetrated by a few powerless academics like Tom Selling, Shyam Sunder, Ray Ball, David Albrecht, and Bob Jensen. Among these protesters, Tom Selling is our persistent champion.

Losing Cause 2 — Mandatory Rotation (Term Limits) of Audit Firms

In 2011 the PCAOB put mandatory audit firm rotation out for discussion. The response from the business community and auditing firms has been overwhelmingly negative to the idea.

The academic community remains largely silent on the issue, but when push comes to shove I suspect that most accounting professors, like me, see more costs than benefits of audit firm rotation even though rotation of the auditor partners themselves on audits is a current practice supported by almost all academics.

Tom Selling remains the lone voice in favor of mandatory audit firm rotation – click here. He proposes something like seven-year term limits before a corporation has to change its audit firm.

Losing Cause 3 — Financial Statements Entirely Based on Replacement Costs

For nearly 100 years leading academics have advocated some type of current cost or value replacement of the historical cost basis of accounting. Historical cost never pretended, as repeatedly noted by AC Littleton, to be valuation accounting. In 1929, John Canning started the ball rolling for current (replacement) cost accounting, which is sometimes called "entry value" accounting. In 1939, Kenneth McNeal commenced the ball rolling for exit value accounting where buildings, vehicles, and factory machinery are valued at what they can sell for, rather than amortized historical costs.

From an academic standpoint the literature on value accounting has probably been more focused upon the bad features (e.g., goodwill accounting) of historical cost accounting rather than on convincing research that some type of "value" accounting justifies the costs of preparation. The sermons on the evils of historical cost accounting became less convincing as research emerged in the 1990s showing that historical cost accounting really did have value for both earnings and stock price forecasting.

John Canning's current (replacement) cost baton has now been passed to Tom Selling. Like John Canning, Tom advocates that business firms spend tens of billions of dollars annually shifting from traditional historical cost reporting of operating assets to replacement costs. The problem is that replacement cost advocates can point to zero research convincing us that the benefits of such drastic changes in financial statements justify the costs.

My Response to Bob

Bob, I appreciate the compliment, especially coming from you. I covet your erudition, and you are the lifeblood of the AECM listserv. We both have strong opinions, and we disagree on some pretty important matters. But, I am proud to say that we both willingly wear our hearts on our sleeves.

I wish I could say the same about most other academics – You state that the academic community remains largely silent on the issue of mandatory audit firm rotation, but I say that the academic community has largely remained silent on all of these issues – IFRS, auditor rotation and independence, and crappy accounting standards (despite the boat loads of narrowly-focused research produced by academics on the information value of GAAP-based financial statements). I believe I am your Losing Cause Many of the Year because academics as a group have proven themselves milquetoasts at this critical juncture for the accounting profession, on which we claim to have a unique and valuable perspective.

I can't know what I would have been writing and saying if I were still a faculty member somewhere, but I would like to think that my training and upbringing would not have permitted me to stifle strongly-held points of view that directly affect my teaching and/or research activities. The accounting professor who denies having strong opinions on at least one of these "lost cause" topics should be asking themselves: what the heck do they spend their time thinking about; whether what they actually are thinking about matters very much to society; and whether they have an ethical obligation to participate in the conversation.

Costs and benefits of change — Bob, you seem to focus on incremental costs (like amounts paid for experts to make various estimations); and I focus on avoidable costs, because I believe they are many times larger:

• The vast amounts spent on auditors and accountants need only be a small fraction of what they are today. Auditors do perform many valuable services; but, some of the services performed require highly subjective judgments and consequently have little value. Those low-value services seem to cost the most, and they challenge the ability of an auditor to be objective.

   

• The amounts of shareholder value destroyed because of "earnings management" and similar games that executives are permitted to play can be stupefying just by recalling the role that financial reporting played in Enron, Worldcom, GM, Lehman, S&Ls in the 1990s, financial institutions over the last few years, just to name a few. If auditor rotation could have prevented just one of these debacles, then your own cost-benefit calculus would be flipped on its head.

   

• There is plenty more value waiting to be destroyed because the system of accounting rules actually encourages it. Bob, you may not agree that replacement cost accounting is the answer, but surely you recognize that financial reporting has many more and far more unsightly warts than simply goodwill accounting! The patchwork of rules we call US GAAP or IFRS is not analogous to the result of some Darwinian evolutionary process of natural selection, as you once said. It is — in spite of (or perhaps even because of) all of the research confirming its predictive value to which you allude — a "garbage truck." (That's not my term; it belongs to David Mosso, a former FASB member no less.)

The end of a tumultuous 2011 may be an appropriate time to recognize a champion of lost causes. But looking ahead to 2012, I see all of these issues in play. Audit rotation may fizzle in the U.S., but it is more alive in Europe; the voices against IFRS adoption are getting louder (even though academics are still sitting on their hands); and once the U.S. escapes from the clutches of the IASB, perhaps we can have a real discussion of value accounting.

2012 is just getting started, and so am I.

I'm for Auditor Term Limits, But …

I was in Minneapolis a couple of months ago, and my client was kind enough to put me up in a very swanky hotel near its offices. While waiting for my dinner at the lobby bar (I don't like to sit alone at a table), I overheard a young woman a couple of seats away mention that she was a Big Four auditor. Let's call her Leslie.

During my brief conversation with Leslie, I learned that: she worked out of her firm's Seattle office; she and about 150 of her colleagues from all over the country would be staying in the hotel for something like three months while they audited a bank; though brimming with confidence, she had only about two years of experience as an auditor; she had never audited a bank before; she knew very little, and seemed to care very little, about how banks did their accounting; and she hadn't the slightest idea what even her first task would be. Basically, all Leslie knew was where she had to be the next morning.

What were the prospects that Leslie, or the minions soon to join her, had the technical qualifications, much less the skepticism and backbone to do more than dutifully perform each task assigned within the allotted time? Why must it take 150 dislocated professionals three months to audit a bank (especially when 100 percent of the records to be examined must have been available electronically? Will the value of the audit exceed even the cost of the massive hotel bill to come?

Read as much or as little from my anecdote as you would like. For me, it is one more vivid reminder that the practice of auditing is in complete disarray; and nothing the PCAOB is considering, including mandatory audit firm term limits, will change that sad state of affairs in any significant way.

Yet, I am still in favor of mandatory audit term limits. At the very least, audit firms will more carefully consider who staffs an audit, how it is conducted, and how it is supervised. At best, it could actually catalyze a fundamental re-thinking of the financial reporting function. Some believe that Armageddon will ensue if mandatory audit term limits were to be put into place, but maybe it will indirectly open the way to the first real discussion since the advent of the securities laws of what ails financial reporting.

What such a discussion should reveal is that neither auditing standards nor auditor conduct are the root causes of the financial reporting failures that have rocked the economy, and the reputation of practitioners and regulators alike. That distinction goes to the accounting standards promulgated by the overpaid FASB, and largely with the tacit support of a moribund SEC. I have maintained here, here and elsewhere that there is no way that auditors can be expected to challenge management's estimates, which permeate virtually every line item on the financial statements. And, this doesn't even begin to address the issue of needless complexity in accounting standards, of which Leslie may have known barely enough to pass the CPA exam on her third try.

It is time to amend the securities laws to enunciate a more appropriate (and limited) role for auditors in the modern economy. It needs to be a role that Leslie can readily understand and perform:

• Verification of the components of financial statements that can be verified.
• Verification of the inputs to current valuations that can be objectively measured, and hence, verified.
• Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

When financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – i.e., neither management, nor the auditor. As a result of that constraint, financial reporting regulators would have to consider the following questions:

• Which inputs and other aspects of financial reporting are subject to verification, and hence covered by an auditor's report?
• Which of these are to be provided by other independent experts? What should be the nature of their representations, and to what extent should auditors verify those representations?

The conventional wisdom is that historic cost accounting is fact-based, objective, understandable, and even verifiable. We have learned the hard way that this is a fiction; however historic cost accounting has been practiced. To get to a point where financial reporting can be useful and reliable, the FASB and SEC must dedicate themselves to the establishment of accounting standards that yield financial statements capable of being audited and understood by people like Leslie.

Sometimes, 'little strokes will tumble great oaks,' but the sad history of financial reporting since the passage of the securities laws is the accumulation of little, half-hearted, chops in random points on the tree. The time has come for a chainsaw.

If that chainsaw is mandatory audit firm rotation, then so be it.

The PCAOB Should Name Names – All of Them

Yesterday's blog post from Jim Peterson (Re:Balance) excoriated the PCAOB for proposing to require audit firms to disclose the names of the responsible engagement partners. Jim claims that the PCAOB is wasting its time: the name of the engagement partner is not relevant information to sophisticated users of financial statements; it's one more piece of information that the average investor won't attend to; and it would only fuel the fires of the "unremitting critics of the profession."

Yesterday, I might have been inclined to agree with Jim; but today, I don't. For today brought news (here, here and here) that PCAOB inspectors had concluded (in 2008) that Deloitte & Touche's quality control system was flawed, and that the firm still has not corrected the problem. Specifically, the inspectors found too many instances were DT auditors placed too much reliance on management's representations – what some would derisively call "auditing by inquiry" – without adequately testing the accuracy of those representations.

Based on what I have read so far, here is what I think an investor is entitled to know in a timely manner, and which has never been disclosed:

1. Which companies were affected by the allegedly flawed audits?
2. Who were the responsible engagement partners?
3. Were the responsible engagement partners disciplined or re-trained in any way?
4. Which other audits could be flawed because the responsible engagement partners were involved?

Unfortunately, my entire line of questioning falls apart at the beginning because of the PCAOB's longstanding (and controversial) policy of not identifying the companies affected when its inspectors have identified a flawed audit.

And, as for timeliness, I have one more question: The original Part I of the PCAOB report was issued in May 2008. By law, DT had until May 2009 to remedy the problems and in doing so, keep them confidential. Thus, the PCAOB could have issued the report it issued yesterday 30 months earlier. What took them so long?

If the PCAOB truly wants the naming of responsible engagement partners to have information and deterrent value, it needs to be more forthcoming itself about the results of its inspections, and to publish the information in a timely manner.

Mandatory Audit Firm Rotation and Greek Bond Accounting: What Might Have Happened?

In my previous post, I provided my reactions to Hans Hoogervorst's recent letter to the European Securities and Markets Authority (ESMA), in which he expressed concern for the pie-in-the-sky numbers produced by some EU banks on their Greek bonds classified as 'available for sale' (AFS). Now, I would like to pose a hypothetical: what if mandatory auditor rotation had been in effect? Would Mr. Hoogervorst's letter have been unnecessary?

As a preliminary matter, I am not asking these questions with French banks in mind. The banks in France are known to report anything they want, whenever they want. The regulators are powerless to stop them; ergo, there is no incentive for the auditors to do anything that would jeopardize relationships with clients. Vive le Société Générale!

So, setting France aside, let's start with a very simple fact pattern:

Mandatory audit firm rotation is required after seven years, and Bank One's current auditor (Auditor A) is in Year 7 of its term. Despite the fact that market prices for Greek bonds have declined by 51%, the management of Bank One maintains that a 21% haircut on its Greek bond investments is all that IFRS requires.

Auditor A knows that Auditor B is engaged for next year's audit of Bank One. Coincidentally, Auditor A will take over the audit next year of Bank Two, Auditor B's current client.

Of the possible actions/outcomes of the Bank One audit engagement, here are four to ponder:

1. Eat or be eaten – Auditor A will insist on a 51% haircut; either because Auditor A actually disagrees with Bank One's management, or it has some ulterior motive. For example, Auditor A's overriding fear could be that the successor auditor (Auditor B) is motivated to clear the decks of all 'gray areas' when it takes over. If such were the case, Auditor B could come in next year and require Bank One to restate Year 7. So, Auditor A could be thinking that it is s a far better thing to administer grief to the soon-to-be-former client than to be grief's recipient – by none less than by another member of the fraternal order of auditors.
2. One hand washes the other – Auditor A and Auditor B collude. They both have promises to trade: Auditor B won't mess with Bank One's Year 7 financial statements if Auditor A promises not to mess with Bank Two's Year 7 financial statements.
3. Safety in numbers – Auditor A will caucus with its peer group, Auditors B, C, D and E – either informally, or through a mechanism akin to the Center for Audit Quality. Since auditors are happy to advocate for their clients as a group, the quality of the accounting alternatives (from an investor standpoint) will not matter to the caucus as much as it should.
4. What goes around, comes around – Auditor A will accede to the client and have confidence that Auditor B won't try to call it to account. Auditor B is likely concerned with being disciplined by the fraternal order of auditors. This is what oligopoly theory would suggest.

You may provide your own subjective probability distribution over these (and perhaps other) outcomes; and draw your own conclusions as to whether mandatory audit firm rotation is worth the costs. But, the analysis shouldn't stop there; my larger point is that mandatory audit firm rotation has to be considered within the context of improving the entire financial reporting regulatory structure.

First, it goes without saying that criminal acts of collusion and fraud must be punished. However, this is not a panacea. If the death penalty doesn't deter murderers, then why should we trust the vows of politicians to enforce the existing securities laws and professional standards with renewed vigor, or to mete out more severe penalties for violations? In the best of circumstances, vigilant bureaucracies eventually fall asleep at the switch; and on the other side of the equation greed is boundless, inventive and infectious.

Second, mandatory audit firm rotation must complement robust audit inspection programs. To see this, simply change the date of my hypothetical from Year 7 to Year 1 of Auditor A's term. Audit firm rotation is so far in the distance in Year 1 that it couldn't possibly have much effect on the auditor's decision making.

The PCAOB's audit inspection programs, while seemingly effective in uncovering irregularities, don't seem to have enough of a deterrent effect. When the PCAOB uncovers deficiencies in an audit, it must publicly identify the auditor, the issuer, the deficiency and the remediation efforts – all in a timely manner. As a matter of principle, the investing public has a right to know which public company (could have) fudged its numbers, and which audit firm is responsible for letting it slip through their fingers. The PCAOB's has an inspection track record of being right far more often than wrong; this record should be used as the justification for undoing the secrecy and procrastination that is inimical to investor protection.

Third, an auditor has a right to be secure in the knowledge that it cannot be dismissed when it takes a stand against management. Mandatory auditor rotation should be accompanied by minimum audit terms, which cannot be lengthened. Once an auditor is engaged, it cannot be dismissed without performance-related cause, and the auditor may not resign simply due to a disagreement.

Finally, it is sad, but true, to state that the only reason why mandatory auditor rotation is being considered is because auditing has drifted too far afield from its original role as envisaged by Congress when it created the first federal securities laws. That role is verification. Today, the auditor's exposure to pressure from clients comes from their role as assessors of the 'reasonableness' of management's judgments. As I have stated repeatedly, and most recently here, it doesn't have to be this way, and I will have more to say on that in a future post.

Peeling the Onion on the Accounting for Greek Bonds

Yesterday, Han Hoogervorst, the IASB chair, sent a letter to the European Securities and Markets Authority (ESMA), in which he expressed concern for the pie-in-the-sky numbers produced by EU banks on their Greek bonds classified as 'available for sale' (AFS). Although I share Mr. Hoogervorst's concerns, they should be much broader than indicated by the scope of his letter. The IASB should be just as concerned with Greek bonds reported in its artificial held to maturity (HTM) category; and it should be profoundly disturbed by the auditor's role in this debacle.

Echoes of Soc Gen

The Greek bond accounting situation is not an isolated event, but merely a flash mob version of the incredible case of Société Générale. To refresh your memory, Soc Gen, a French bank, chose to dump rogue trader Jérôme Kerviel's 2008 trading losses (about $10 billion) into fiscal 2007. The effect of the 2007 makeover was to partially offset his gains of the previous year, and to give 2008 a clean slate so, I presume, management could get its earnings-based bonuses. There is no disputing that the losses occurred in 2008, yet the bank took the outlandish position that application of straightforward and sensible IFRS rules (marking derivatives to market through net income) would, for reasons unstated, result in a failure of the 2008 financial statements to present a "true and fair view."

You might also be interested to know that Soc Gen's financial statements, as is apparently the norm in France, were opined upon by not just one, but two (yes, two!) auditors. Could Soc Gen have been wrong to invoke the "true and fair" exception if both of its venerable Big Four auditors – Ernst & Young and Deloitte & Touche – gave the financial statements a clean opinion? C'est imposible!

Then, as now, the IASB cried foul, and if history is a guide, its sound and fury will again come to naught. In Europe, just as in the U.S. (I am compelled to add), the banks play the tune.

If You Don't Like Market Prices, Just Make Something Up

Getting back to the present, Mr. Hoogervorst's beef with European banks is that trading markets were discounting Greek bonds by over 50%, yet many banks were only giving the bonds in their "available for sale" portfolio a 21% haircut, the amount that the desperate Greek government averred their own bonds should be worth after all is said and done. Hoogervorst did not identify any offending institutions by either example or name, but the Associated Press has helped out with a few: BNP Paribas and CNP Assurances (a French insurance company) took only a 21% writedown on their AFS Greek bonds, but Commerzbank of Germany wrote the exact same bonds down by 51%.

Also sprach Hoogervorst:

"It appears that some companies are not following IAS 39 when determining whether the Greek government bonds that they classify as AFS are impaired. They are using the assessed impact on the present value of future cash flows arising from the proposed restructure of those bonds, rather than using the amount reflected by current market prices as required in IAS 39.

In addition, some companies holding Greek government bonds classified as AFS have stated that they are relying on internal valuation methodologies, rather than on market prices, to measure the fair value of the assets as at 30 June 2011. The reason generally given for using models rather than market prices is that the market for Greek government bonds is currently inactive (and therefore, in their view, does not provide reliable pricing information).

….[However, a ] … company cannot ignore observable transaction prices when it is clear that market participants are regularly entering into transactions for the same or similar financial assets, even if they are doing so less frequently than they have in the past." [emphasis supplied]

Lack of consistent enforcement is just one of the many reasons that the notion of a single set of, high quality global accounting standards is, in this blogger's opinion, a practical impossibility. If the Société Générale debacle has faded to a distant memory for some, then this case should be an additional reminder to the SEC that genuine comparability cannot possibly exist absent rigorous enforcement. In Europe, it seems, even token enforcement is absent.

And, speaking of the SEC, I wouldn't be surprised if some of the financial institutions taking insufficient writedowns also maintain U.S. listings. It will be interesting to see if the SEC tries to put the heat on them. And, if anybody reading this post knows of any such companies, I would appreciate knowing about them.

Other Problems Hoogervorst Might Prefer Not to Discuss

There are at least three other troubling aspects of IFRS that the Greek bond accounting debacle has exposed.

Accounting for bonds that are classified as held-to-maturity — While Hoogervorst's letter only addresses inconsistencies in measurements of AFS portfolios, the Greek bond crisis also makes it clear that HTM accounting exists for the convenience of issuers. This is for two reasons.

First, management has extremely broad discretion in measuring the amount of impairment. This is because the carrying amount of the HTM investments is based on a totally arbitrary calculation: management's subjective estimate of the future cash flows it will receive, discounted by the original yield to maturity. Unlike the AFS portfolio, there is no requirement to refer to current market prices, and so long as an auditor does not object, management can pick pretty much any number it wants.

For example, AP also reported that although Commerzbank took a 51% charge to their AFS Greek bonds, they also have Greek bonds that are classified as HTM; and for these, they only took a 21% charge. There is simply no way that the IASB can justify these internally inconsistent measurements for identical assets, even assuming that both numbers were produced in compliance with the extant accounting rules.

Second, even if management were to actually make a loan impairment assessment in good faith, the result is a completely arbitrary calculation that defies explanation in economic terms. The resulting number can only be described by the calculation that spit it out. There is nothing more that investors can glean from it, other than an acknowledgement from management that it doesn't expect to receive all of the payments the bank is contractually entitled to receive.  In respect to the Greek bonds, that's not much of a revelation.

And, by the way, I wonder how Commerzbank got that arbitrary calculation to come out to exactly that 21% figure the Greeks want everyone to accept – and don't? As I am about to explain, this case (just like Soc Gen) reveals that at least in Europe, getting one's auditor to agree that management's assessment is 'reasonable' may be the least of management's problems when faced with the consequences of an unfortunate investment decision.

The Vast Inconsistency of Audit Judgments — It just so happened that PwC was engaged to audit all three of the companies mentioned in the AP article. It seems impossible to get around the conclusion that PwC found a 51% haircut on Commerzbank's AFS Greek bonds was 'reasonable', and that a haircut of less than half that amount was also 'reasonable' for BNP Paribas's holding of the same bonds. It seems as if the credibility of the numbers reported by some of these European financial institutions are not worth the paper they are printed on; and by extension, the same conclusion would apply to the reports of their 'independent' auditors.

I wonder if Hoogervorst had considered writing to the Big Four instead of, or in addition to, ESMA. To me, anyway, it is more important to have the Big Four justify its acceptance of vastly different amounts of write downs on the same debt held by two or more different banks. At least the auditors are supposed to be gatekeepers; but ESMA, ironically, has absolutely no enforcement authority on any company.

If the IASB will not be asking the Big Four, the hand that feeds them, for answers, who will? What does this say about IASB independence?

Lastly, the the HTM problem is bigger than the AFS problem – And, don't expect it to get fixed any time soon. The IASB's financial instruments project is a bust on many levels. But with respect to HTM loans, the Board's good book/bad book approach to loan loss allowances is being scrapped, albeit not for any accounting that makes more sense. Instead, the IASB is getting ready to propose a three bucket approach whose only apparent purpose is to allow lenders and bond investors even more discretion to manipulate loan loss allowances and earnings.

. . . . . . . .

Hans Hoogervorst's letter has also reminded us that a single set of global accounting standards has no traction without consistent application and enforcement of the rules. The SEC didn't get the message after Soc Gen, but how about now?

Why Won't the SEC Investigate Motorola … Again?

The following is more (see my earlier post) from PCAOB chair Jim Doty's June 2^nd speech, describing an auditor's failure to correct an accounting misstatement that was "galling in its simplicity":

"PCAOB inspectors found at one large firm that an engagement team was aware that a significant contract was not signed until the early hours of the fourth quarter. Nevertheless, the audit partner allowed the company to book the transaction in the third quarter, which allowed the company to meet its earnings target. Although the firm discussed the timing of the transaction with the customer, it failed to obtain persuasive evidence of an arrangement for revenue recognition purposes in the third quarter. The company had been an audit client of the firm for close to 50 years." [Italics supplied]

Obviously, Doty used this case to illustrate the independence problems inherent in excessively long auditor tenure (in this case, nearly 50 years). And, consistent with long-standing, albeit questionable, PCAOB policies, Doty would not name names. But, once Bloomberg columnist Jonathan Weil plucked the parties' identities and some other sordid details from court records, this case appears to have left egg on the face of the SEC as well:

[KPMG's and] Motorola's identity [now known as Motorola Solutions Inc.] was disclosed in public records last month as part of a class-action shareholder lawsuit against the company in a federal district court in Chicago. The plaintiffs in the case … filed a transcript of a September 2010 deposition of a KPMG auditor, David Pratt … "

Jon goes on to report that the size of the alleged deception was just as galling as the simplicity decried by Doty. The plaintiffs are alleging that Motorola inappropriately recognized $275 million of earnings during the 2006 third quarter, or 28% of net income.

SEC MIA?

Why has the SEC apparently not followed up on the PCAOB's findings? For one thing, the PCAOB inspection report provides highly credible evidence of a very large accounting misstatement made by a high-profile registrant, and with the apparent complicity of its Big Four auditor. It doesn't necessarily mean that the PCAOB is correct in its allegations, but someone should called to account by the SEC: if not Motorola and/or KPMG, then the PCAOB for a faulty inspection report.

For another thing, this case is certainly not an isolated instance for KPMG, or for that matter, Motorola. In May 2007 the SEC found that Motorola knowingly helped Adelphia Communications Corp. cook its books way back in 2000 and 2001. The 'assistance' Motorola provided to its valued customer took the form of a sham "marketing support" transaction that amounted to nothing more than a roundtrip of cash. In settlement of the SEC's proceedings against it, Motorola agreed to pay a $25 million fine and consented (without admitting or denying guilt, of course) to the entry of a cease and desist order against cooking its own books -- or anyone else's.*

Technically, I suppose, Motorola can't be accused of violating the SEC's C&D order when it allegedly cooked its own books in 2006, since the C&D order wasn't issued until 2007. But, the C&D certainly does gum up the works. With hindsight, at least, the sanctions already imposed by the SEC on Motorola would have been more severe if the SEC had known about the 2006 violations, and which the PCAOB discovered soon afterwards. In particular, no individuals at Motorola were sanctioned. One might also ask whether the 2006 alleged violations could have been prevented by the SEC, if they had not taken so long to settle the earlier ones?

And, what should become of Motorola's long-standing auditors, KPMG? They apparently knew of Motorola's questionable accounting in 2006, because they consented to it. But, inquiring minds now want to know if KPMG had also been aware of (and perhaps complicit in) the sham transaction with Adelphia. But, even if their hands are clean on the Adelphia matter, how is KPMG going to defend its issuance of a clean attestation report covering Motorola's internal controls over financial reporting?

When I was at the SEC, way back in 1992-93, it seemed that the Enforcement staff would grab all of the low hanging fruit they could get their hands on. Most the time, the open and shut cases involved small issuers and small auditing firms. But, I was never under the impression that the largest issuers and their auditors were out of bounds. As the SEC's decision to not seek sanctions against Motorola and KPMG defies a reasoned or principled explanation, it looks like either politics, indifference or incompetence are to blame. 

What This Case Says about Auditor Term Limits

I had originally reported on Jim Doty's speech out of my interest in promoting enhanced audit reliability through mandatory audit firm term limits. The clear implication of Doty's remarks is that KPMG's decades-long relationship with Motorola eventually became more obstructive than protective. I'll close this post with the following observations and conjectures:

• Even apart from the effect on its brand and integrity, the actual direct costs and potential losses to Motorola from this litigation probably wiped out any of the 'audit efficiency savings' from its half-century monogamous relationship with KPMG. I see no legitimate justification for Motorola to retain the same auditor for that long.
• Would anyone be surprised if the allegedly improper accounting were also linked to questionable bonus payments?
• What is currently on the minds of the members of Motorola's audit committee? I would not be surprised if the committee has never even addressed whether KPMG bore some responsibility by failing to detect the existence of the sham transaction with Adelphia.
• Given the PCAOB's latest findings, the litigation and the latest publicity, does the audit committee still support retaining KPMG? If so, what are they thinking?

---------------------

*The technical prohibitions, known as 'books and records provisions' are to be found in Sections 13(a) and 13(b)(2)(A) of the Securities Exchange Act of 1934 and SEC Rules 12b-20, 13a-1, and 13a-13 t him hereunder.

Audit Firm Term Limits: Nothing Else Left to Try

This post more or less (actually somewhat more, than less) mirrors my answers to questions posed by Matt Kelly, editor of Compliance Week in a recent podcasted interview. The subject was audit firm term limits, or mandatory audit firm rotation; and Matt had invited me to do this with him after reading my post on PCAOB chair Jim Doty's recent remarks.

Also, before I get started, I want to mention that in preparing for my interview with Matt I took the liberty of calling a couple of friends to elicit their views and bounce off ideas. Thanks to John Hufnagle and Gaylen Hansen for that.

On Changeover Costs

Assuming auditor rotation comes to pass (a big assumption, we know), what would the practical effects be for financial reporting or internal auditing executives? They'd face more complicated encounters with their auditors if new firms rotate in every few years, no?

In order to answer any question concerning incremental costs of auditor term limits, it would be helpful to know why average auditor tenure is currently so high. Is it purely because clients are seeking to avoid switching costs – such as more encounters with auditors to bring them up to speed on their client – or is it because even well-intentioned executives benefit from holding greater power over long-tenured auditors.

We also know that many executives complain that even long-tenured auditors impose significant switching costs on their clients, just because of the year-to-year turnover involving middle and lower staff. It could well be the case that auditor term limits might reduce that kind of turnover from changing assignments within the firm.

Whatever the ultimate answer to questions of changeover costs, I do agree that the PCAOB should be sensitive to these questions before any form of term limits are imposed, and I expect they will be. That's because term limits would be a fundamental change, and as I will describe later, there is virtually no chance that a political consensus can be achieved beforehand. If the PCAOB is going to move towards term limits, it's pretty safe to assume that they will move cautiously.

 

What's the Payback for Term Limits?

Would auditor rotation actually achieve the immediate goal of fewer audit failures?

That's a question that certainly goes to the heart of the issue, actually in two ways. First, there is the implicit premise to Matt's question: that the purpose of auditor rotation is to reduce the number of audit failures.

I would say that this is too narrow a specification of the problem. For one thing, it has already been well-publicized that in our earnings-obsessed business environment the executive suite denizens derive a large portion of their compensation, either directly or indirectly, from hitting earnings-based targets. In that environment, there is always the potential for a broad swath of shareholder value destruction should auditors subordinate their judgment to management. We probably wouldn't call that an audit failure, but it is a scourge nonetheless; there are billions of dollars of potential savings from term limits if it serves to curb excess executive compensation.

Second, we are debating this issue today, and the PCAOB is considering it, because of Lehman, AIG, Worldcom, Enron and a number of others mega-failures that contributed to severe disruptions in the economy as a whole. Audit failures below this level, even if they attracted the attention of the public, like Koss, are small potatoes compared to the potential savings if even one or two of the big ones could have been prevented by auditor term limits.

Auditor Incentives

More broadly, would a fresh set of eyes on the financial statements actually solve the problem of making audits more useful to investors? Or is this answer, audit rotation, somewhat separate from those larger concerns that audit reports aren't that useful anymore?

Actually, the beneficial effects of auditor rotation begin with the re-freshening of old eyes – the eyes of the incumbent auditor. In the fifth year of a 7-year relationship, will the incumbent auditor be feeling comfortable because it has worked smoothly with the client for five years, or will it feel uncomfortable because some yet-to-be-disclosed successor auditor will have every incentive to examine each page of the old working papers with a fine tooth comb?

But, to answer Matt's question more directly, and in the spirit of Jim Doty's "holistic approach," there are at least these three dimensions to the problem: auditor independence; the content and scope of the audit report; and the quality of the accounting standards on which the audited financial statements are based. With respect to the last one, some would say that the much of the problems at Lehman, Citigroup and WAMU is that these firms are not just too big to fail without severe fallout, but they are so complex that a reliable audit may not even be possible. How much of this problem is simply due to the fact that the accounting standards themselves are too darn complicated, counter-intuitive and oversaturated with abstractions that an auditor is simply in no position to evaluate? Answer: lots. And, don't kid yourself, IFRS is no better.

Politics, Politics, Politics

Do you think that the audit industry is going to mount a fight? What sort of battles are we looking at: titanic clashes or minor skirmishes?

Absolutely titanic. Doty's alluded to this in his speech when he mentioned that Congress considered adding term limits to the Sarbanes-Oxley Act in 2002. I believe that Paul Sarbanes, the Democratic Senator from Maryland, placed mandatory audit firm rotation at the foundation of the bill he first envisaged. It was vigorously opposed by the AICPA for successor auditors pitted against predecessor auditors would have been, and still is, their worst nightmare come true.

Into the breach stepped Michael Oxley, a Republican Representative from the state of Ohio and well-known supporter of the accounting profession. Oxley was also the Financial Services Committee Chair in the House. Using the largely unsubstantiated argument that audit firm rotation would be far too costly, most of the burdensome responsibilities on corporations in the Act — CEO/CFO certification, SOX 404, new board and audit committee requirements, to name a few — were added by Oxley in exchange for giving the ax to mandatory audit firm rotation. The happy ending for the AICPA was that not only could they avoid auditors auditing auditors, SOX 404 gave them a windfall in the form of new services for which they could charge an arm and a leg.

But, too be fair, I do see two political challenges to term limits. Perhaps the bigger of the two is that we don't have a lot of evidence that audit firm rotation is going to work. (But, that didn't stop Congress from enacting SOX 404.) The only country that has tried auditor term limits was Italy, but relative to the U.S., Italy is a country has less-developed capital markets, fewer investor protections and less effective enforcement mechanisms).

The PCAOB will, from the outset of its studies and deliberations will face an uphill battle to get past the objections of the AICPA, without much hard data to support their argument. But, Doty seems to be ready for that. Few, except for AICPA shills will question the fact that there are fundamental problems with the ways that audits are currently being conducted, and that poor quality audits (and financial reporting in general) contributed to the financial crisis. Moreover, just about everything else, except for auditor term limits has been tried; and according to the findings of PCAOB inspectors, there are far too many audit failures, many of which could be explained by impaired independence.

The second challenge is determine whether term limits should be imposed on smaller issuers and smaller firms. For reasons stated above and others that are probably obvious, I think not.

In supporting audit term limits, my working assumptions are as follows: (1) fixing financial reporting rules so that financial statements can be audited reliably is a hopeless and frustrating goal that will elude regulators for another generation or more; (2) adding more verbiage around an inherently unreliable process will only smear more lipstick on the pig; and (3) every other device for loosening the bond between auditor and client has been tried and fallen far short of the mark. Therefore, audit term limits seems to be the only reasonable near-term response for breaking the vicious cycle of financial crises and erosion of public confidence in financial reporting.

PCAOB Shifts into High Gear under Jim Doty

Lots of "rethinking" has been going on of late. There's a new SEC staff paper rethinking how to take IFRS adoption/convergence off life support; and the FASB and IASB are rethinking how much they can give away to special interests regarding capitalized costs and onerous contracts in their revenue recognition project.

But, new PCAOB chair, Jim Doty's recent speech, "Rethinking the Relevance, Credibility and Transparency of Audits is what I'll be writing about -- if only because once in a great while I need to write encouraging thoughts on the future of financial reporting. Most refreshingly, not once did Doty even remotely indicate that US auditing standards should be 'converged' with international standards. That sets him apart from all too many policy makers, who are obsessed with devolving US financial reporting into something palatable to the whims and vicissitudes of the European Union, China, and each and every Third World country.

Doty took pains to emphasize that he remains open to all suggestions; but the fact remains that PCAOB inspectors have uncovered far too many problems, in far too many audits, to conclude that something short of broad-based change is called for:

"We need a holistic approach to addressing the cultural challenges inherent in auditing, based on a deep, fact-based analysis of the problem. By a 'holistic approach,' I mean addressing relevance, credibility, and transparency of the audit by all available and effective means."

As John Hufnagle summarized it in his blog, Doty's PCAOB is considering reforms on several fronts. I have re-arranged them to reflect my own priorities, in descending order:

• Strengthening the "independence" rules (perhaps by mandating periodic audit firm rotation)
• Enhancing the auditor's report;
• Adding required communications to audit committees about the results and processes of PCAOB inspections;
• Adding a requirement that the engagement partner, in addition to the firm, should sign the auditor's report.

Independence: Shall We Continue to Play Make-Believe?

I'm going to focus on independence; and frankly, Doty didn't start out as I would have liked (although he ended in a good place):

"To perform their role properly — to assure that reported financial and economic successes are not illusory — auditors must approach their jobs with independence and skepticism. They cannot allow themselves to be caught up in their audit clients' business goals. How do we instill those necessary traits in auditors? This may be the most important auditing question of our time."[Emphasis supplied]

In other words, once upon a time, auditors were selfless professionals who could be relied upon to subjugate their individual interests for the greater good. Somehow, as the world changed in bad ways, auditors' "traits" changed with it. Someday, hopefully, a prince will come to make the world the wonderful place it once was, and to give the auditors their "necessary traits" back.

Obviously, I don't believe those halcyon days ever really existed, except perhaps in popular myth. The notion that the rest of society should trust a profession as a whole (or its individual members) to have the integrity to subjugate personal interests for the greater good (particularly when the stakes are high) is an antiquated false premise upon which the entire system of financial reporting has been built — and which surely no one seriously believes in anymore. Yet, it is precisely the notion from which the auditing profession has profited greatly and is now desperately clinging to for dear life.

As much as it pains me to say it, Doty is probably acting wisely by choosing to avoid a frontal assault on the concept of an independent audit, even if he thinks, as I do, that independence is a myth. The apparent strategy is to leave the myth intact while focusing on making changes to the reality to effectively bust it without actually saying so.

* * * *

"The PCAOB has now conducted annual inspections of the largest audit firms for eight years. Our inspectors have reviewed more than 2,800 engagements of such firms and discovered and analyzed hundreds of cases involving what they determined to be audit failures. We have conducted more than 1,500 inspections of smaller domestic firms and of non-U.S. firms. These include multiple inspections of hundreds of those firms. And our inspectors have identified hundreds more cases involving what they determined to be audit failures.

Based on this work, I believe it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against. I don't have a predetermined idea as to whether the PCAOB ultimately should adopt term limits. My only predilection is that the PCAOB deepen the analysis of how we can better insulate auditors from client pressure and shift their mindset to protecting the investing public.

As such, the Board plans to issue another concept release to explore whether there are other approaches we could take that could more systematically insulate auditors from the forces that pull them away from the necessary mindset. [Emphasis supplied]

Here again, Doty is taking a more prudent tack by introducing mandatory audit firm rotation (i.e., "term limits") without immediately embracing it, or comparing it to other alternatives. But, similar to the independence myth, if the PCAOB can be left to an unfettered and objective judgment, it will find that every other idea for "insulating auditors" except for mandatory audit firm rotation will run the risk of being ineffective. Everything else is more going through the motions: more rote disclosures, and more procedural charades.

Perhaps, Doty, may yet find a way to give audit firm rotation a silver lining. For example, if auditor objectivity could be controlled, it may make sense that auditors should be allowed to pitch other services that dovetail with the audit. A holistic approach to improving audit quality could lead to recognition that mandatory audit firm rotation, while creating restrictions, could also create new opportunities for auditors — so long as there are clear limits on when, what, and how much non-audit services would be appropriate to take on.

Remaining Concerns: Too Much Said in Some Ways, and Not Enough in Others

Overall, Doty's speech sets the tone, and establishes a plan for action, that is the kind of effort I applaud and am proud to observe. Yet, I do have concerns with the holistic approach. One the good side, there will be so many proposals put out for comment that some of it surely has to stick. But, will it be the right stuff? One scenario I fear is that the PCAOB will be forced by political pressures to settle for changes that will make a great press release, but will fail to address the systemic problems.

But, it's nice, for once, to feel that investor advocates don't have to beat their heads against every wall in Washington.

The Stars and Goats of the Senate Hearing on Accounting

I am trying hard to be optimistic, but there are more than a few indications that a Senate investigation of the accounting profession's role in the economy – which began last week with a two-hour hearing by the Subcommittee on Securities, Insurance, and Investment – will fizzle out before it gathers momentum. But, there are also reasons for hope.

The formal title of the hearing was "Role of the Accounting Profession in Preventing [Yet] Another Financial Crisis." Each of seven panelists were given about 10 minutes to make an opening presentation and to answer a few questions, mostly coming from the subcommittee chair, Jack Reed, Democrat from Rhode Island. Notably, not a single question came from Republicans; in fact, nary a one so much as deigned to attend.

There's politics for you, that not even a mother could love. Yet, I am encouraged somewhat that at least a few lawmakers are ready to fight the good fight. There were certainly some stars at the hearing, but even without the boycotting Republican senators, the hearing also had its share of goats.

The first star of the Senate hearing goes to James Doty, PCAOB chairperson. To appreciate just how important he was to the proceedings, imagine if he were replaced by some implacable apologist from some stonewalling AICPA committee. Were it not for provisions in S-OX that established a PCAOB to be governed by non-accountants (see S-OX sec. 101) that's the sort of audit profession leadership we would have. Doty is also being backed by what could be emerging as the most formidable and influential investor group, the PCAOB's own Investor Advisory Group, which certainly would not exist without S-OX.

Unlike the FASB, which seems to studiously ignore the protestations of its own Investors Technical Advisory Committee, Doty appears to have taken to heart the recent scathing indictments of auditors by the PCAOB's IAG. The most telling moment of the hearing was Doty's unequivocal acknowledgement that auditors should have delved deeper into valuation, going concern and end-of-period issues before issuing their clean opinions on financial institutions that ultimately disintegrated in one way or another. Moreover, these auditors lacked the independence from management to go to them or the audit committee to sound an alarm, even if they suspected a problem.

The protestations of another panelist notwithstanding, which I will get to below, there is no getting around the fact that audit failures played a significant role in the financial crises. But, while Doty's commitment that the PCAOB will look at the auditing model, which "has not changed in more than 60 years" is encouraging, there are indications that the PCAOB's project will not be as comprehensive as it needs to be. As I stated in an earlier post, merely changing the language of the audit report, and/or supplementing it with additional disclosure prepared by the auditor cannot be expected to fundamentally change audit effectiveness. Nothing less than a fundamental reassessment of the role of auditing in public company financial reporting can begin to accomplish what is needed after the three auditing Armageddons in three decades: the S&L crisis, Enron et al, and the 2008 financial crisis.

The second star goes to Senator Reed, who teed up the issues rather well in his opening remarks and questioning. Capital markets need effective audits, and the receipt of unqualified opinions by all of the major financial institutions in the period leading up to their demise has, only a few years after S-OX, raised the same questions regarding auditor independence, audit scope, and ultimately whether a clean audit opinion provides valuable information to capital market participants.

Reed didn't say this explicitly, but I think the subtext of his questions were this: it's one thing to say that the fundamental causes of the financial crisis was poor decision-making by managers; but it must also be asked how deficient accounting and auditing rules facilitated those actions. The disintegration of major financial institutions did not occur from a single blow, and warnings had been issued by numerous credible commentators. Yet, none of these seemed to have registered sufficiently with auditors and regulators. The apparent result is that all of the financial statement revelations of value destruction that was years in the making arrived too late to be of much benefit to investors and bank regulators.

The third star belongs to Lynn Turner, the last panelist to give his prepared remarks. Don't just compare Doty to the hack who would have sat in his place absent the PCAOB. Compare Lynn Turner, a former SEC chief accountant himself, to the current chief accountant, James Kroeker was obviously standing in for SEC chair Mary Schapiro. Schapiro would have risked revealing her ignorance of accounting and auditing if she had attended. As for Kroeker, stand in is just what he did; he might have had more affect on the hearings if he were an ashtray.

Turner observed, as Kroeker should have and with more than a trace of resignation, that the questions being asked that morning haven't changed for the last 25 years. The FASB has consistently failed to issue timely standards that work; and it should at least be requiring additional disclosures to when adherence to a rule results in misleading financial statements (think, for example, Lehman's repo transactions). Under the rules that we have, banks failed to report losses that had been incurred over a number of years, and the standards to limit off-balance sheet accounting have failed. Audit committees are not as engaged as they should be, and the SEC has been more like a lapdog than a watchdog.

To the Goats We Must

After Bob Herz was relieved of his duties as chair of the FASB – because he (rightly in my estimation)believed in reporting the fair value of loans and separating the informational needs of investors from the needs of bank regulators (my opinion) – the job of leading the FASB devolved to Leslie Seidman. The hearings hit rock bottom no less than three times while she was speaking.

First, Seidman's opening remarks were a waste of time. They were a by-the-book and useless overview of the FASB and the FAF, and an empty defense of independent standard setting. In other words, everything is under control; the SEC should remain the lapdog while the FASB fiddles, postures, and caves to special interests through some amorphous protocol masquerading as "due process." I am truly sorry to have to report my impression that, in comparison to Doty, Seidman was the bland bureaucrat, lacking energy, vision and no apparent purpose higher than self-preservation.

Second, Reed asked why the FASB had not eliminated the abuses from accounting for off-balance sheet transactions, as directed by S-OX? The best that Seidman could say was that the changes that had actually been made were an "improvement" over the standards that existed at the time. But, Reed wanted to know why OBS tricks couldn't be fixed and dealt with more comprehensively, as Congress intended?

No help. And, of course, Seidman did not volunteer that off-balance sheet lease accounting is, almost ten years later, still alive and well, and available for abuse.

The third nadir was plumbed when Seidman chose not to respond to Senator Reed's concerns about whether auditing is just a loss leader for other services, or whether the fear of telling truth to power will find the auditor out on the street. To the obvious bemusement of Reed, Seidman demurred on the basis that auditor backbone was not something she knows about – even though she worked as an auditor, and as an assistant director of implementation and practices at the FASB.

Cynthia Fornelli, executive director of the Center for Audit Quality is my second goat (or maybe even tied with Seidman) for stating with a straight face that "everybody agrees" that this was not a crisis caused by auditing and accounting; and following that up by suggesting that auditors could help prevent another financial crisis if they were to attest on more than just the financial statements.  Such a notion had been more or less summarily rejected by the SEC shortly after the S&L crisis. A few years later, the AICPA did promulgate a set of attestation standards that would cover MD&A, in hopes that some companies would voluntarily purchase an attestation report, but I know of not one company to have done so.

Most bothersome to me about Fornelli is that the substance and tone of her remarks foreshadow a pitched battle with any reforms that Jim Doty's PCAOB might attempt. She leaves little doubt that the CAQ will strenuously lobby against any proposal that could take money out of the pockets of auditors. While the PCAOB will be making a good faith effort to understand how the accounting profession contributed to past failures in order to find a way forward, don't count on the accounting profession to do anything except to erect roadblocks.

The Prospects for the Future

Taking the remarks of Turner and Doty together, the subcommittee cannot escape the conclusion that financial reporting is broke, and what's worse, key stewards of financial reporting are either misguided or dysfunctional.

On the bright side, Jim Doty, if his skin is thick enough, could make history at the PCAOB. But, without an SEC renaissance and a fundamental reform of accounting standards, a reform of auditing standards can't possibly be more than a half measure.

I wish I could be more optimistic.

Less from Auditors Would be More

The Senate Subcommittee on Securities, Insurance and Investment has announced that it will meet this Wednesday to conduct a hearing entitled "The Role of the Accounting Profession in Preventing Another Financial Crisis."

"The witnesses on Panel I will be: Mr. James R. Doty, Chairman, Public Company Accounting Oversight Board; Ms. Leslie F. Seidman, Chairman, Financial Accounting Standards Board; and Mr. James L. Kroeker, Chief Accountant, U.S. Securities and Exchange Commission. The witnesses on Panel II will be: Mr. Anton R. Valukas, Chairman, Jenner & Block LLP; and Mr. Lynn E. Turner, Former Chief Accountant, U. S. Securities and Exchange Commission.…" [bold in original]

If I could whisper in the Subcommittee's collective ear, I would congratulate them on picking a topic to investigate that finally has some chance of calling auditors and financial reporting regulators to account for their role in the financial crisis. But, if they actually want helpful responses, they should focus their questions to Panel I on Jim Doty. James Kroeker is obviously there to be the punching bag for Mary Schapiro, who surely won't risk revealing her ignorance of financial reporting to hostile members of Congress; and both Kroeker and Leslie Seidman have been so IFRS-fixated for so long, and have had so little to say on the Subcommittee's topic, it's doubtful they are in a position to do little more than defend and deflect. If they actually testify under oath that adoption of IFRS should be part of the solution, I think I might become sick.

Doty should be pressed for his opinion of the views recently expressed by the PCAOB's Investor Advisory Group (IAG), which recently stated:

"The recent financial crisis presented auditors, and by extension the Sarbanes-Oxley Act audit reforms, with their first big test since these reforms were put into place. By any objective measure, they failed that test." [italics supplied]

"… Serious questions have been raised both about the quality of these [failed] financial institutions' financial reporting practices and about the quality of audits that permitted those reporting practices to go unchecked."

"While auditors did not cause the financial crisis, it is difficult to look at the list of failed institutions that received an unqualified audit just months before they failed and conclude that auditors didn't play a role."

Even though Doty's PCAOB is discussing modifications to the auditor's report, the Subcommittee should question whether that alone is a sufficient – or even a logical first – response to the fundamental issues of audit processes and auditor independence that have been raised by the PCAOB's advisory group.

If I could also whisper in Doty's ear, I would congratulate him, too, for his apparent willingness to support whatever it might take to improve the quality of audits of public companies. I would also advise him to use the impetus of an outraged public and his own recent appointment to re-evaluate the foundations upon which financial reporting regulation is based. These can be found in the Securities Act of 1933:

[A prospectus of an issuer must include] "… a balance sheet… showing all of the assets of the issuer, the nature and cost thereof… [and an income statement] in such detail and in such form as the Commission shall prescribe… [and]… certified by an independent public or certified accountant." [15 USC §77aa(25), emphasis supplied]

I would argue that the IAG's conclusions and the Subcommittee's motivation spring from a common source of concern: the last two decades have convincingly demonstrated that it is no longer practicable to expect that auditors can serve the same watchdog role that the 1933 Congress envisaged for them. Auditors may still perform the same basic functions today, but their relative importance with respect to their impact on financial reporting quality has shifted drastically. Basically, I see auditors doing three distinct things:

1. Verification of those components of financial statements that can be verified — for example, cash receipts and disbursements; amounts owed; and amounts owing.
2. Assessments of the reasonableness of estimates made by others — for example, bad debt allowances, useful lives of long-lived assets, cost allocations, and the likelihood of future events.
3. Monitoring the application of accounting standards – for example, timing of revenue recognition, determination of the functional currency of foreign operations.

Of these three functions, I can't imagine that Congress was anything but focused primarily on verification processes, as the extant (limited) accounting rules and procedures largely prescribed cost-based measurements. We could have a wonderful discussion as to why accounting standards have become as complicated as they are today, but that is not the central point for the Subcommittee. The IAG's conclusion that auditors have repeatedly failed to keep management on the straight and narrow when the stakes were highest is practically inarguable. Whether this is the fault of poor-quality auditing standards, or poor implementation of those auditing standards is also not the fundamental issue. Stated bluntly, history should have taught us by now that auditors might be good at verification of things which are capable of being verified, and very little else. This, Mr. Doty and members of Congress, is the crux of the problem we must now confront.

While one is tempted to be cynical as to the real purpose of a congressional hearing on financial reporting, the possibility that an audit of the financial statements taken as a whole, a costly and legislatively-mandated process, has become obsolete suggests a proper role for today's Congress. It should amend the securities laws to enunciate a more appropriate (and limited) role for auditors in the modern economy – where the historic cost of tangible assets has become a largely irrelevant consideration. When financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – neither management, nor the auditor. As a result, the scope of the audit would be limited to:

• Verification of the components of financial statements that are capable of being verified.
• Verification of those inputs to current valuations that can be objectively measured, and hence, verified.
• Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

In response to the Enron et al financial reporting crisis, Congress allowed itself to be persuaded that additional attestation services were an appropriate response to audit failures. If Jim Doty can manage to reverse the tide of higher audit fees as audit reliability continues to degrade, he will become my hero. And in the process, he should find that the questions that have recently been raised regarding independence, quality, the content of the audit report, and audit firm concentration will all become much easier to answer.

New PCAOB Chair Appears to Have His Heart in the Right Place

After I left the SEC, Executive Enterprise Institute signed me up to produce and chair various SEC and financial reporting courses. Our collaboration is still going strong, and they have given me lots of exposure to guest speakers, many of whom have played significant roles in capital markets regulation. Without wishing to make comparisons to others I have been privileged to meet, I distinctly remember James Doty, the new PCAOB chair, for his energy as a speaker, positive outlook, genuinely friendly demeanor, and openness to other points of view.

But, just because somebody is a genuinely nice fella, it doesn't necessarily mean he will lead the PCAOB as investor advocates believe it should be led. I decided to write this post after reading blogger Francine McKenna, who suspects that the SEC has sold investors down the river with the appointments of the three new board members. Francine's inculpatory evidence against Jim is that he did good business defending accountants and auditors in court. As you will see from reading this post, I am actually quite hopeful that Jim will follow in the footsteps of Charles Niemeier, former PCAOB chair, who himself did quite well in the same line of business. As with Niemeier (fomer enforcement chief accountant), I would expect that Doty's performance while at the SEC (former general counsel) is a better gauge of his fitness to lead the PCAOB.

Doty at the SEC – In His Own Words

The world has changed a lot since the early 90's, when Jim was the general counsel. The SEC brand had not yet been tarnished by partisan politics of the past ten years, and ignominious asleep-at-the-switch billions of dollars blunders. Jim Doty provided his personal take on his time at the SEC in a comprehensive interview sponsored by the SEC Historical Society. It could be the best glimpse we have at Doty's regulatory and financial reporting philosophies; so, what follows are a few snippets from the interview, mixed in with my own observations.

Derivatives – Doty thought very highly of Richard Breeden, who had indeed accomplished a great deal as SEC chair; and in the areas where Breeden failed to achieve his objectives, history has proved him tragically correct. For example, Breeden was strongly in favor of enhanced derivatives regulation, and he wanted to coordinate equities and derivatives regulation by merging the CFTC and the SEC; but, he ran into opposition from his own (Republican) party.

"[Breeden] saw, clearly, the need to do it [regulate derivatives]. He saw the fact that so much of the market's activity was shifting into this area that you couldn't monitor and determine capital requirements." [page 22]

And here we are, 20 years later, with bankers still insisting that we should measure capital adequacy under GAAP. (Kindly see my post on this vexing problem.)

Corporate governance –

"Richard believed, even then I think, that it was wrong for management to be self-perpetuating. People were tinkering with and considering proposals that looked like direct [proxy] access [to nominate board members], what we're now looking at." [p. 25]

Fair value – Breeden recognized that mark-to-market accounting for loans was the logical accounting policy response to the S&L crisis, and Doty is still singing the same tune:

"Regulatory accounting principles had been identified by everybody as having something to do with the failure of the system that had been in place to regulate the federally-insured depository institutions that were S&Ls. Richard very much believed in mark to market accounting and transparency. He believed that the volatility that occurred as a result of that transparency was better than the potential for serious misunderstanding and misstatement that occurred with historic cost accounting for financial instruments. He was in a very difficult position because he was also talking to Japanese, Mexican, European, and British regulators." [p. 34, italics supplied]

Nothing much has changed there! Elsewhere in the interview, Doty readily acknowledged that lack of high quality accounting standards for financial institutions played a significant role (although not the only role) in the banking debacles to come.

The status of GAAP – Against immense political pressure, Breeden held the line on compliance with GAAP by foreign issuers, while at the same time liberalizing other requirements to enable foreign companies to raise capital in the U.S.:

"[Breeden] also, of course, said, 'First of all, we're not going to abandon GAAP. If you're Deutsche Bank [sic, Daimler-Benz?] and if you want to offer your securities and list them on the New York Stock Exchange, you'd better provide a footnote that reconciles your earnings and your reserves to GAAP.' He, of course, was exactly right." [page 34, italics supplied]

And as to adoption of IFRS, Doty concludes the interview with this observation about Mary Schapiro:

"If you want to look at one that Richard Breeden was talking about … look at mark to market accounting, and look to GAAP and the principles-based accounting, and look at Mary [Schapiro], who's undergoing all these political pressures now, dealing with all these pressures, and what's she doing with IFRS? She's saying, of course, globalization is a fact of life: you can't be against harmonization, reconciliation and one uniform system accounting, but we're not there yet. We don't know what it is. Of course, she's right. They can't. They can't allow (or require) all companies to go to IFRS when there's Taiwanese IFRS and Milanese IFRS and Argentinean IFRS." [p. 48, italics supplied]

Will Jim Doty Walk the Talk?

The PCAOB's formative years occurred while any small deviation from the party line as enunciated by Christopher Cox would not be tolerated (a true definition of 'political correctness'). Once again, the case of Charlie Niemeier is instructive, as he was the first government official to deliver a tour de force critique of the SEC's misguided plans to jettison GAAP in favor of IFRS. While there is nothing to suggest that Doty will need to be as confrontational with the current SEC administration, I hope (and predict) that he will, like Breeden, seek to leave his mark on financial reporting. It would be too easy to be a caretaker chair, merely overseeing incremental improvements to the practice of auditing without declaring any sense of larger purpose. For that, Doty should start with a forceful articulation of his vision for financial reporting, and the role auditors should be expected to play in a more investor-friendly system. Jim should be able to come up with about 80 percent of the necessary ingredients from his recent interview with the SEC Historical Society.

We know what Jim Doty stands for, and he has demonstrated that he knows how to play the role of regulator with conviction. Here's hoping for a repeat performance.

 

 

The Big Four: Too Few to Fail

As I wrote a few weeks ago, the most recent display of public handwringing is taking place in Europe over the distinct possibility that one of the Big Four could be forced out of the auditing business. According to a more recent editorial in the Financial Times, four mega firms is copacetic, but three is not. Actually, only four is not OK, because three is definitely not. Jim Peterson constantly reminds us on his blog that the existing four-firm dominance is a systemic financial accident waiting to happen; if things continue the way they are going, it's more a question of when, not if.

We need at least a fifth firm, but preferably lots more, that are capable of taking on the largest corporations as clients. Surely, the public has learned more than they could ever have wanted to know about the concept of moral hazard from the too-big-to-fail banks. And just as surely, the Big Four are too few for financial regulators to let fail. This version of moral hazard is that each of the firms knows the position the financial regulators are in, and they take on more risk as a result.

Saving the Big Four from Themselves

We are in the current pickle in no small part due to the governmental failures to stop at least two of the three big mergers when they had the chance. We can't put that genie back in the bottle, but if accounting firms had incentives to combine, we should also be able to provide them with incentives to divide. In a previous post, I suggested that the U.S. federal government could offer to share certain litigation exposures from any Big Four firm that agrees to split into two completely separate firms on U.S. soil.

Here's another idea. Similar to the 'support fees' that are currently assessed on public companies to fund the operations of the FASB and PCAOB (in proportion to their market capitalization), Congress could create a fund to be used for compensating the partners of Big Four firms that split themselves up. The fund could be doled out on a first-come-first-served basis; or the government could hold auctions; or it could issue a request for proposals and award money based on the attractiveness of the offers.

Nobody is Happy

But, none of these solutions fix the root causes of the problems with the auditing profession. While reading an report in NYT a couple of weeks ago about gasoline engine manufacturers in Japan (perhaps the best in the world) that are struggling mightily to cope with the inexorable market shift toward hybrid and electric vehicles, my one-track mind wandered back to financial reporting: historic cost accounting is to a gasoline engines as current values are to electric vehicles. But, while governments are firmly behind the mass adoption of electric vehicles, the EU, IASB and the U.S. Federal Reserve are actively discouraging financial reports to shareholders that are powered by state-of-the-art measurement (see, for example, IFRS/GAAP) of financial instruments.

The Big Four owe their lock on the largest companies in the world to the complex accounting rules rooted in 1930's concepts. But the sad irony is that nobody is as happy as they could be with the current state of affairs. The public has learned to distrust auditors and to fear a systemic financial crises triggered by the collapse of one of the Big Four. The audit firms have been forced to focus on the least profitable service they offer due to regulatory restrictions on non-audit services designed to maintaining at least some hazy appearance of "independence."

Unlike car engines, auditing will not be modernized by market forces. It will take the actions of financial regulators, like the SEC and the European Commission to protect the public – and the audit firms themselves from the shortsighted interests of their current crop of senior partners. Here is what a sustainable system of financial reporting could look like:

• A company's board of directors would engage an independent auditor; and separately, independent appraisers to determine the current values of assets and liabilities reported on the balance sheet.
• Management would prepare income statements, cash flow statements, and roll forwards of all balance sheet accounts.
• The independent appraiser(s) would provide separate report(s) describing the scope of their work, the extent of their reliance on management for information, and detailed descriptions of the methodologies they employed for estimating values for tangible assets owned by the company, and for the company's contractual rights and obligations.
• The auditors would perform the following functions:
  • Confirm the physical existence of tangible assets and management's assertions as to the existence of contractual rights and obligations.
  • To the extent required by notes accompanying the financial statements, verify the accuracy of schedules that report past cash flows and contractual future cash flows.
  • Confirm the independence of the appraisers and verify the completeness and accuracy of their work.
  • Verify the completeness and accuracy of management's work.
  • Issue an audit report describing the scope of work, findings (e.g., that the auditor is not aware of any material misstatements), and that they exercised the appropriate level of diligence.

Everybody would be happier. The 'expectations gap' between what an auditor says it does and what it delivers would be eliminated; and since the nature of the audit function would change, the regulators could safely roll back their restrictions on non-audit services. Most important, the stranglehold on large clients by the Big Four would be loosened, because the client would no longer have to depend on the auditor's mastery of disconnected rules that nobody except a few folks in the national offices have a clue about anyway.

Accounting doesn't need to be converged. It needs to be fundamentally reformed so that anyone can audit a big multinational corporation, just so long as they have access to enough people in enough places.

Manufacturers of gasoline-powered engines in Japan can either: (1) change, or (2) lobby their government for international and domestic trade protections. Financial reporting could use a lot more of that first one.

 

 

Reforming the Market for Audit Services: Some Advice for the EC

M. Michel Barnier
European Commissioner for Internal Market and Services

Re: Green Paper, "Audit Policy: Lessons from the Crisis"

Dear M. Barnier:

My fellow blogger, Francine McKenna, has recently observed that the negative consequences of "Big Four" dominance of auditing services to the largest EU companies have been a topic of concern for a number of years. I commend you for the publication of the Green Paper, and your personal commitment to effect significant reforms in the next calendar year. As an American, I am also hoping that constructive actions taken by the European Commission will serve as a catalyst for similar reform in my country. To these ends, I am writing to provide you with my own analysis of the problem, and the apparent solution.

Why Audit Reports Are Unreliable: More than a "Big Four" Problem

The first paragraph of the Green Paper states, in part, as follows:

"The fact that numerous banks revealed huge losses from 2007 to 2009 on the positions they had held both on and off balance sheet raises … the question of how auditors could give clean audit reports to their clients for those periods [footnote omitted] …"

Unfortunately, the audit process has become encumbered by two fundamental flaws, which explain why the audit reports referred to in the above quotation have become unreliable:

First, auditors lack sufficient incentives to perform their duties in good faith – During the hearings leading up to the passage of the U.S. Securities Act of 1933, representatives of the accounting profession successfully convinced the U.S. Congress that government involvement in corporate audits would not be necessary; and the public could safely rely on the "conscience" of auditors to perform their function with an independent state of mind.

But, "independence" as a conceptual underpinning of auditing has proven to be a failure. Imagine how difficult it must be for the new partner-in-charge to be inserted between the rock that is your firm's highly profitable relationship for more than 20 years with the audit client, and the hard place that is management's gross underestimation of bad debt reserves? To be sure, too many auditors have at critical moments, shown that their "conscience" could be defeated by the temptations of the material world. The chances are very good that whichever accounting scandal you can name, pre- or post-crisis, the same auditors had been engaged for decades.¹

As I am sure you are aware, the reasoning underlying proposals for mandatory audit firm rotation is that it could potentially offset the known limitations of the independence assumption.  Successor auditors would have a strong economic incentive to perform a thorough initial review of prior financial reports, so as to avoid exposure for restatements occurring on their watch. Knowing this, the predecessor auditor has an economic interest in not being found to have committed an oversight, and should be ever the more diligent as a result.

Second, and notwithstanding questions of good faith, the judgments that are required to produce a set of financial statements diminish the reliability of an audit² – Some financial elements are capable of being determined objectively (e.g., cash and contractual amounts for receivables and payables); and auditors are relied upon to verify that such elements are correctly stated. This is well within an auditor's area of expertise and entirely appropriate.

However, and as you well know, dozens of financial statement elements depend on management's subjective estimates of unknowable future events. The problem of audit reliability is almost entirely due to requirements for the auditor to state that management's judgments and statements of intent "appear reasonable." The problems inherent in this approach are material to all reporting entities, but may be particularly acute for financial insitutions and their holdings of financial instruments, which cuts to the heart of the most recent economic crisis.

Developments in accounting stndards, most particularly the recent changes undertaken or proposed by the IFRS at the behest of the EC, are moving toward greater reliance on management's estimates and statements of intent. The EC in supporting these efforts, is actually making the problems identified in your Green Paper even worse, for they are rendering audit reliability ever more questionable and salient as a systemic threat. How is the auditor supposed to attest to the reasonableness of a management assertion that an identified contingent liability is not "capable of reliable measurement"; or that a required measurement procedure would entail "undue cost or effort"; much less an estimate of bad debt losses over the next twenty years? Neither the PCAOB nor the IAASB can be expected to provide adequate guidance for auditors on these critical aspects of their work, and I would hazard that they have not even begun to contemplate some of the audit questions that have arisen from some of the newer forms of management's assertions and estimates.

A Proposed Solution

If the EC's immediate objective is to increase audit reliability, and thereby reduce systemic risk to the financial sector the economy, then mandatory audit firm rotation would be a logical place to start. However, based on the experience in the U.S. leading up to the Sarbanes-Oxley Act, the Big Four will fight tooth and nail against such a proposal. Acting in concert with the AICPA, these firms successfully lobbied Congress to actually broaden auditor services to include an attestation report covering the functioning of their client's "internal control over financial reporting" (Section 404 of the Act). As you are no doubt aware, issuers have had mixed reactions to Section 404, and I doubt that the EC would even consider imposing the considerable transition costs on companies that are already struggling during the global recession.

But, even if the EC summons the will to rebuff the efforts of special interests and require mandatory audit firm rotation, this alone will not reduce the stranglehold of the Big Four on the largest companies in the EC. Because of the fundamental flaws in the audit model I have described above, smaller firms will not be able to benefit by ramping up their capabilities to function in the current financial reporting environment. This is just one reason why I firmly believe that financial reporting itself must be reformed; for in addition to the goal of providing better information to investors, the EC should lower barriers to entry so that more audit firms can economically serve the largest companies, and enhance audit reliability.

To reform financial reporting, the EC should:

• Move to replace cost-based models for reporting assets and liabilities with current values.³
• Estimates of current values should be provided by third parties, and not management or the auditor. 
• Auditor involvement should be limited to: verifying the inputs to the valuations that can be objectively measured; attesting that the third party valuation experts seemed to behave in an objective manner; and that the third party valuation experts performed the procedures they said they would perform.
• The valuation experts would provide their own reports to accompany the financial statements.

Conclusion

Financial reporting is at a crossroads, and there is every indication that incremental adjustments to the system that has contributed to the global financial debacles of the past decades will do little to help prevent future debacles. It is not enough to solve the problem of Big Four concentration amongst the largest companies in the EC.

Thus, the bad news is that only a comprehensive solution has a chance of effecting the reform that is so badly needed; and special interest groups will fight fiercely as one to maintain their franchises. But, the good news is that the best solution is both simple to implement, and simple to explain. Investors want information about wealth and changes in wealth; and they want that information from reliable sources that are independent of management.

M. Barnier, if you want a quick fix to the problem of audit reliability, then I would suggest that you implement a system of mandatory audit firm rotation post haste. But, if your mission is to create a financial reporting platform on which the EU's economy can recover and grow, then you should form a new accounting standards board to create a comprehensive basis of accounting predicated on current values and financial reporting transparency. Systemic risks will be reduced, barriers to entry for auditing services will be lowered, and so will the cost of capital – all in one fell swoop.

I wish you the best of luck in your endeavors.

Notes

1. In 2003, the U.S. Government Accountability Office reported that the average tenure of auditors to the Fortune 1000 was 22 years.
2. For helping to crystallize my own thinking on this topic, I am indebted to Walter Schuetze's (former SEC Chief Accounting and founding FASB member) remarks to the New York State Society of CPAs, Auditing: Objective Evidence vs. Subjective Judgments, on September 9, 2003.
3. Both the FASB and IASB generally prefer (with certain exceptions) to estimate current values in terms of exit prices, but my strong preference is for entry prices (i.e., replacement costs). The difference between these two approaches is not inconsequential on many dimensions. However, due to space and time constraints, I will reluctantly disregard these differences in order to keep the focus on higher-level features of my proposal.