The Accounting Onion

HP's Autonomy Debacle: Mistakes were Made -- and Capitalized?

Companies overpay to acquire other companies all the time; but Hewlett Packard Co. just might be the new record holder for getting fleeced. I don't have the exact amount, but let's say that the goodwill HP initially recorded from the E.D.S. and the Autonomy acquisitions combined was on the order of $20 billion. Given the subsequent goodwill impairment charges for most of it, and the revelations that surrounded those charges, it should come as no surprise that investors have expressed dissatisfaction with everyone – management and the board, their outside financial advisors and auditors – associated with the decision making and the accounting for these ill-fated investments.

One very compelling expression of dissatisfaction came recently in a letter from the CtW Investment Group to Rajiv Gupta, HP's lead director and chair of its corporate governance committee. CtW works with pension funds, which in the aggregate are substantial HP shareholders. Supported by a detailed nine-page analysis, CtW has called for nothing less than "…a comprehensive overhaul of the board's oversight of the audit process and the replacement of long-time outside auditor, Ernst & Young."

Highlights of the claims made by CtW against EY are as follows:

• Large amounts of non-audit fees paid to EY in recent years, although not technically prohibited, challenge the presumption of its independence from HP.
• However, HP was a lobbying client of Washington Counsel, which was owned by EY: "We further note that it has been reported that the SEC is investigating Ernst & Young for allowing its … subsidiary to lobby for audit clients."
• The timing of the $8 billion goodwill impairment charge in 2012 relating to the 2008 acquisition of E.D.S. "reveals a significant performance failure on Ernst & Young's part." CtW's analysis of reported results indicate that significant goodwill impairment(s) should have been recognized in earlier years; and the delay in recognition resulted in misleading reported earnings for those years.

One of the motivations of this post was simply to bring to your attention this letter, which if substantiated, has important implications for EY and for financial reporting in general. But, a second motivation is to further discuss the accounting for goodwill, using the Autonomy debacle as a case study. This is the way that CtW teed up the issue I want to explore:

"Ernst & Young, as HP's independent auditor, had a duty to review HP goodwill accounting in its 2011 Form 10-K and for its 2012 financial statements. Ernst & Young did not discover any improper accounting practices [at Autonomy], nor does it appear to have objected to the amount of goodwill HP recorded in association with the Autonomy acquisition." [emphasis added]

Auditing Initial Goodwill is Not Necessarily about Goodwill

I'm sure that most readers already understand that goodwill is nothing more than the difference between the purchase price of the acquisition* and the opening measurements of all the identified assets acquired and liabilities assumed. Setting aside what goodwill on the balance actually means or doesn't mean, the CtW letter does not explicitly acknowledge that an auditor's responsibility for the initial amount of "goodwill" recognized actually begins with examining the non-goodwill amounts. In practice, goodwill itself would rarely be an object of scrutiny by the auditors; but more on that later.

The CtW letter does indicate a concern that EY missed something very important in its examination of Autonomy assets acquired and liabilities assumed. In this regard, it notes that a PwC forensic investigation of Autonomy's accounting uncovered "…a variety of inappropriate and arguably fraudulent accounting practices, including improper timing of revenue recognition…" But, while the PwC investigation doesn't bode well for EY it is not, as CtW seems to imply, because EY may have allowed initial goodwill to be overstated.

To illustrate this point, let's just focus on one particular asset acquired: customer accounts receivable. It has been alleged that Autonomy improperly recognized revenue from agreements to resellers of software licenses, even before a single license had been sold to an end user. Presumably, the improper revenue recognition would have caused customer receivables to be overstated.

But, if EY did not compel HP to back out any premature recognition of receivables, then the arithmetic business combination would not have been reflected in a misstatement of total assets. Even though customer receivables would have been overstated, it would have been offset by understated goodwill. That's why I wish CtW had framed its concerns in terms of the reported amounts for the non-goodwill assets acquired and liabilities assumed, instead of goodwill itself.

But, it is also possible that EY discovered a misstatement in, say again, customer receivables; and it compelled HP to reduce the receivables accordingly. If this had been the case, then EY looks better in one respect and worse in another; because, if EY had permitted HP to offset the downward adjustment in customer receivables with an increase in goodwill, then the issue that CtW raises is manifest: goodwill was artificially inflated, and EY might have noted that fact.

My sense is that if EY missed something it is more likely that they failed to note an overstatement of customer receivables. But, the reason I wanted to discuss this alternative scenario is because the accounting for 'mistakes' in a business combination is frequently problematic.

'Mistake' Capitalization Happens All the Time

I suppose that one could justify initial capitalization in goodwill of some mistakes – like overvaluing future prospects – because they are impossible to detect at the time a transaction takes place. For example, shortly after an acquisition is consummated in good faith by both parties, and before the first financial statements are issued, an acquiror might learn that its forecast of future profitability was too optimistic. But, if customer receivables are found to actually not exist at some point before the financial statements are issued, how should that be handled?

The FASB Accounting Standards Codification is silent on this point, but it turns out that the SEC took a position on a similar matter a number of years ago. I stumbled upon that position in a fascinating interview of Clarence Sampson, SEC Chief Accountant for more than a decade starting in the mid-1970s. Of his many tales of peculiar interactions with special interests, this one impressed me the most:

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

The amount of shareholder value destruction from the E.D.S. and Autonomy debacles were extreme, but the fact of the matter is that mistakes in major acquisitions happen with great frequency, if not most of the time. There are business school academics who spend virtually their entire careers trying to explain why it is so often the case that an acquiror's stock price goes down (i.e., shareholder value is destroyed) after plans to acquire another company are announced. During my part-time career as litigation consultant, I have been involved in at least four cases where acquirors have claimed that assets they purportedly purchased either didn't exist, or were worth much less than the amounts recorded on the balance sheet of the acquire.

In all of those cases how did a mistake get accounted for? Capitalized as goodwill, of course!

In a nutshell, Sampson stated the obvious: despite what the accounting rules say – or don't say – an asset that doesn't exist can't be goodwill. But, just so everyone should get the message, two things ought to happen:

First, no matter at what point subsequent to the acquisition date that the errors in Autonomy's financial statements were discovered, HP should not have capitalized them in goodwill; therefore, the SEC should require HP to correct its accounting error by restating all periods affect – and perhaps also by amending previously filed financial statements in which the erroneous amount of goodwill was reported.

Second, the FASB ought to use this case to echo that sentiment. It should amend U.S. GAAP to make it clear that when a company thought it bought it asset, but didn't, the asset that never existed is not goodwill.

I am not a supporter of recognizing goodwill as an asset under any circumstance, but if it is to be, then it should be clear that when it is discovered that an asset is overstated or does not exist, that's clearly not goodwill.

Perhaps, then, companies like HP will be more careful about: what they acquire; what they pay; and what the contracts state about what they are entitled to if assets that are purported to exist in fact do not.

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*To you accounting sticklers, I know that my description is technically accurate only if an acquiror purchases 100% of the outstanding shares of the acquiree. For the purposes of this post, that's close enough.

Why Nothing Sticks to Auditors when Loans Go Bad

I read numerous news sources this week echoing the SEC's announcement that it finally has a case it thinks it can win against auditors stemming from the 2008 financial crisis. One journalist, Jon Weil of Bloomberg, takes it a step further to ask, 'What took so long'?

"It has been frustrating to look at the SEC's own highlights of the lawsuits it has filed in connection with the financial crisis -- and to see that none of them had been against an auditor. Now the SEC will have one case to cite, albeit against a couple of small fries. It also should be stressed that the agency hasn't proved any of its allegations against these two accountants. Surely the SEC can find some bigger targets out there in the auditing world if it wants to. [emphasis added]

Actually, Jon, it can't.  The paucity of enforcement actions against auditors surely has not been for lack of trying. But, just as surely, auditors have not been doing much lately to protect investors and to promote economic stability. The topic of audit reform in response to the financial crisis has been everywhere in both the U.S. and Europe (except perhaps where it counts the most – at the SEC).

The SEC announcement comes coincidentally right on the heels of the FASB's proposal to make changes to loan accounting. Which adds another question to Jon's: would better loan accounting standards beget higher quality audits? But more on that later. First, let's discuss why auditors have been to financial reporting as Teflon is to frying pans – nothing sticks.

 

The Problem of Auditing what Managers See through Rose-colored Lenses

I've explained this before, but it bears repeating. Several financial elements are capable of being determined objectively (e.g., cash and contractual amounts for receivables and payables). Auditors are trained to verify these financial statement inputs by counting, reading, confirming, etc., and they generally do an outstanding job at this kind of work – for which any CPA is eminently qualified.

However, dozens of financial statement elements depend on management's subjective estimates of unknowable future events and myriad scenarios based on complex contracts that are often engineered solely to confound. The problem of audit reliability is almost entirely due to requirements for the auditor to state that management's judgments (in which they often have a direct interest) and mere representations of intent "appear reasonable." The impossibility of auditing the ineffable cuts to the heart of any bubble-induced banking crisis – past, present or future.

As Jon Weil observes, even if the SEC prevails in its modest quest to hold at least a couple of auditors accountable, the message value will be minimal. Moreover, for the reasons I've just stated, there is reason to fear that the SEC won't get its case past an administrative law judge (ALJ).

The SEC's case reads well. The auditors allegedly should have seen that internal controls were inadequate, they had reason to know that management's estimates were biased, and they ignored important information concernin the value of loan collateral. But, there are at least two sides to every story; and the SEC may have to meet a very high standard for its side to prevail.

If the auditors don't settle, then (follow me on this one) the SEC will have to convince the ALJ that the auditors acted "unreasonably" by not concluding that the numbers fed to them by management were themselves "unreasonable." Basically, the SEC has two shots, and I have feeling that neither one is a slam dunk. Under Section 4C of the Exchange Act, the SEC can show either one of the following: at least one instance of "highly unreasonable" conduct; or "repeated" instances of merely "unreasonable" conduct that together indicate "lack of competence."

I don't want to get into a lot of details here, but these particular standards are less than 20 years old; and they have not been tested in court very often. What is important to know (and the irony to appreciate) is that in an audit engagement or in a court of law, determining what is reasonable in the context of financial reporting is a quixotic venture. It may not matter that in this case, according to Jon Weil, the bank regulator – and not the auditor – caught the accounting errors; and the auditor resigned only weeks before the bank failed in 2010. As a matter of law, none of that may speak to the question put before an ALJ.

My guess is that the auditor is willing to put the SEC to its proof because they estimate that there is a good chance of prevailing. If they do, it will be helpful in defending against all sorts of civil litigation, where the real money is involved. (By the way, Section 4C which was added by Sarbanes-Oxley in 2002, does not permit the SEC to seek monetary damages from accountants. Maybe it should?)

 

The Only Way Forward

If I am right about the reasons why auditors have avoided SEC sanctions for their shoddy bank audits, then one must also conclude that the FASB's and IASB's proposals will accomplish nothing. Readers of financial statements will continue to be at the mercy of management wearing rose-colored lenses in bad times and creating rainy-day reserves in good times; and auditors will look on with impunity.

The facts are that holding management ultimately accountable for the accuracy of financial statements doesn't work anymore (if it ever did). Different auditing standards won't make the audit more reliable as a deterrent to financial manipulation, so long as management has the license to do the estimating – and to hire and fire the auditors.

Fundamental change is required, and that can't happen by simply leaving the IASB and FASB to their own devices. Beginning with the premise that investors want information from reliable sources that are independent of management, the only way forward is for reporting of loans to be based on fair values, which are produced by independent valuation experts. If that can be made to happen, then auditor involvement can be limited to things that every CPA already knows how to do:

• Verify the inputs to fair value measure that can be objectively measured;
• Attest to the adherence of professional standards by the independent valuation experts;
• Verify that the independent valuation experts performed the procedures they were supposed to perform.

Auditors might make less money on audits, but there are benefits.  There are arguments to be made that some services that are now prohibited, should not be seen as threats to auditor independence. They won't be spending their profits defending against civil litigation and the SEC. 

They'll sleep better.

Pick a Number: Anything but Market for Loan Accounting (Part 2)

In response to my previous post, Edith Orenstein (author of the FEI blog and fellow Ohio State alum) asked me whether I preferred the status quo "incurred," or the proposed "expected" loan loss model (CECL).

Also in that post, I stated that I would have more to say about how the FASB defined "expected" in the CECL model. As it turns out Edith's question makes for a good lead in, so I'll take on both of these questions here.

The Expected Loss Model is a Move in the Wrong Direction

Actually, Edith, both models are terrible because they both require estimates of future cash flows over a loan term of 5, 10 or even 30 years out. It's ridiculous to presume that these numbers are much better than seat-of-the-pants guesses – even for the plainest vanilla loan contracts.

But, I'm not going to evade your question: the proposed "expected" loan loss model is worse.

CECL is worse because it violates basic economic logic and reasonable accounting conventions. How can the value of a loan at its inception be anything different than the net proceeds to the borrower? This was the logic for the incurred loss model; but under the CECL model not only can the carrying amount be different than economic reality from the get go, but it must be different – and that difference must be recorded as an expense on the income statement.

When a cash outflow does not give rise to an "asset" as defined by applicable accounting standards, it is perfectly understandable that a corresponding expense must be recognized. But, this CECL contrivance is different: the cash outflow to the borrower clearly gives rise to an "asset," and there is no precedent I can think of to justify recognizing only a part of that asset.

There is also the matter of discount rates in both models. I discussed in my previous post how the CECL approach is discounting numbers that aren't actually cash flows; at least the current model at least purports to discount cash flows, but with an arbitrary discount rate. What approach is worse? Let's just say that they're tied for last in a two horse race and we'll leave it at that.

So, on a scale of 1 to 10, I rate the CECL model a minus 3, and I give the incurred loss model a solid zero. As I am about to explain, the proposed CECL model will not provide relevant information to investors and regulators. It is merely another iteration of the "anything but market values" movement driven by bankers and auditors.

Pick a number … pretty much any number.

As Edith pointed out, I was pretty "acerbic" (her word) in my criticisms of the CECL model. But, I actually saved the most insidious aspect of the FASB's loan impairment proposal for last:

"The estimate of expected credit losses is neither a 'worst case' scenario nor a 'best case' scenario, but rather reflects management's current estimate of the contractual cash flows that the entity does not expect to collect.

That helps a lot; it's management's estimate, and just like that old accounting joke about two plus two, management can pick pretty much any number it wants.*

The FASB's boilerplate approach to defining expected losses will not fix the problem of overstated loan balances during a financial downturn. But, there is a method to the madness. To see what that could be, let's tryout a saner solution: how about requiring management to provide its best estimate of future uncollectibles – i.e., the number the bank CEO would bet her own house on instead of the shareholders' and taxpayers'?

The 'problem,' with this solution is that it would put even the best intentioned auditors on the hook to do something they are not qualified to do. If management must estimate in good faith the expected loan losses (i.e., the number that is just as likely to be too high than too low), then how is an auditor supposed to provide reasonable assurance that management actually did what was required of them? Perhaps the auditor could re-perform management's task, but given its complexity and the number of judgments required, it would be unlikely to come reasonably close to management's estimate. Then what?

Alternatively, the auditor could simply review management's estimation methods and parameters, check a few calculations, and then in their infinite wisdom pronounce to the world that management's estimate "appears reasonable." The problem with either of these audit approaches is that when then next financial crisis hits, auditors' judgments will be second-guessed – and if history is any guide, rightly so.

But, if the FASB's boilerplate is finalized, auditors' lives will be improved. For starters, they will finally be able to get those persnickety PCAOB inspectors off their backs. Management can throw out the number it wants investors to behold, and auditors can keep themselves relatively protected from litigation merely by devising some rote procedures that must inevitably find that the number management picked was neither the best nor the worst case.

My point, Edith, is that the question of an expected or incurred loss model is a distraction from the real issue. By whatever model, the numbers won't mean anything – and neither will the auditor's report.

There is a better way.

These are the reasons why I have repeatedly maintained that it is essential for the carrying amounts of loans to be estimated by independent third parties and not management – regardless of the measurement basis for those carrying amounts.

Neither auditors nor management are qualified to provide unbiased and reasonably tight estimates of loan loss allowances; but even if you want to dispute that, it is indisputable that auditors can much more reliably provide assurance as to whether a third party is independent, competent, and that it did what it was supposed to do.

Which brings me full circle back to market value. If an independent third party is going to measure the carrying amount for bank loans, why should it be estimating anything other than market value?

The real question is not incurred versus expected loss models. The real question is why the FASB, despite every common sense indicator, is sticking to its mantra of 'anything but market value.'

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*As an aside, I don't know what "current" is supposed to mean – as of the balance sheet date, or date of the issuance of the financial statements? It's an important distinction.

A Lesson in Loan Accounting from an Unexpected Source: Oil and Gas Companies

[This is my fourth consecutive post on loan accounting. Here are the first, second and third.]

I love finding accounting lessons buried in stories that on their surface seem to have little to do with accounting. See, for example, my post on the appalling politics of joint replacement databases, "No Escaping the Politics of Information." The example I'm going to describe here is a little bit closer to home than body parts: an August 11th, WSJ article headlined, "For Chesapeake, a Question on How it Counts Reserves."

Some background: in January 2004, Royal Dutch Shell announced that it would have to reduce its "proved" oil and gas reserves by 3.9 billion barrels, which was about 20% of their reserves. Another 2 billion barrels were written off in the ensuing months.

The gist of the WSJ article is that ever since the Royal Dutch Shell writedowns and the ensuing securities fraud claims, reserve quantity reporting practices evolved to obtaining some level of outside assurance from independent experts. Consequently, Chesapeake's share price may be discounted by investors because, "[Only] seventy-seven percent of the reserve estimates … reported for 2011 were produced by independent engineering firms, while the rest came from a growing team of in-house reservoir engineers. A survey of nine of Chesapeake's competitors in the same year showed third-party involvement in 89% of reserve estimates, on average."

Chesapeake challenges the claim that its share price is depressed by the possibility of unreliable reserve estimates. While "third-party involvement" could take the form of audits of in-house estimates, or independent estimates, a Chesapeake spokesman claims that its use of third party estimates is more heavily weighted toward independent estimates, while its peers go the other way.

 

An Analogy to Accounting for Loans

But, whatever the particulars of the facts and circumstances surrounding Chesapeake, there are interesting comparisons to be made about loan loss reserves and oil and gas reserves.

The first thing to consider is that accurate estimates of future loan defaults are extremely critical to any evaluation of the financial health of banks, just as "proved" oil and gas reserve quantities are to energy companies.

Second, I would argue that estimates of oil and gas reserves are inherently more reliable than estimates of loan loss reserves. Even though oil and gas reserves could be thousands of feet underground, they are tangible, and they can be sampled and probed. Please don't ask me to cite any of it, but there must be scads of theoretical and empirical scientific studies to support the validity of the methods employed.

In contrast, estimates of loan loss reserves are ineffable; and methodologies for predicting future losses are, to say the least, controversial.  It's a paradox that oil and gas managers engage outside experts to estimate reserves for financial reporting purposes; yet bank managers, who have the more subjective task, think they know enough to estimate loan loss reserves all by themselves.

Third, the SEC requires a financial statement audit of every public company, including banks and energy companies; however, it doesn't require an audit of oil and gas reserves [see Regulation S-K Item 1202(a)(7) and (8)]. Largely in response to the Royal Dutch Shell debacle, managers of oil and gas companies have voluntarily engaged independent experts, whose reputations must perforce depend on their track records, to provide a higher level of assurance to investors than required by law. Obviously, the same can't be said for banks' measures of loan loss reserves.

Fourth, estimates of loan loss reserves are much more critical to the global economy than estimates of energy reserves. Given the market forces that moved oil and gas company managers to act, it seems that another debacle like Royal Dutch Shell is unlikely; but if it did occur, it probably wouldn't shake up the markets as much as a major restatement from a too-big-fail bank.

And what's the likelihood of a bank having to correct its loan loss reserves? There are whole countries in Europe whose banking systems could be on the brink of collapse!

Are financial statement audits of banks helping to allay your fears? Not mine!

Consider as well that audits of loan loss reserves are at the top of the list of deficiencies uncovered by the PCAOB. Even setting aside the question of whether auditors are capable of evaluating bank managers' clairvoyance, all too frequently, it seems, auditors have not even adhered to their own protocols.

 

The Moral of the Story

If you buy into the analogy, and I believe it is quite compelling, then, just as energy companies employ independent scientists, banks should be required to obtain estimates of loan loss reserves or market values (I would much, much prefer the latter) from outside financial experts. Maybe then, market prices of bank stocks and book values would converge. As it is now, investors don't believe the banks' "audited" numbers. Investors surely understand that auditors can and should verify facts, but they are not qualified to predict the future, or even to merely offer an opinion that management's prediction of the future appears reasonable.

In the case of oil and gas companies, the vicissitudes of capital markets led to higher quality financial reporting. But alas, vested interests in entrenched and outdated regulations are preventing it from happening at banks. I am a strong proponent of securities regulation, but sometimes it can get in the way of needed improvements to the information available to investors.

This is one of those times.

Can Auditors Help Save Spain's Banks? Nuts!

Less than a day after posting my critique of the FASB and IASB loan loss allowance proposal, I happily learned that the FASB may be backtracking. According to a PwC In Brief:

"After considering the results of outreach efforts and constituent feedback, the board unanimously agreed with concerns that aspects of the "three bucket" impairment model are complex and difficult to understand. As a result, the FASB will not move forward with an exposure draft on the "three bucket" impairment model …

The FASB's decision to explore a revised approach could result in an impairment model that differs from the IASB's model. During today's discussion, certain IASB members indicated that they have heard much less concern about the "three bucket" impairment model and therefore, plan to move forward with that approach. ….

It is unclear at this time whether the IASB will move forward with an exposure draft in the near term, or whether the IASB will first consider any revised proposals from the FASB." [bold italics supplied]

Dare I now hope that the FASB will ultimately rediscover the wisdom of measuring loans at market-based values? I would be more optimistic that reason might prevail if the newest three board members hadn't been specially chosen by the powers that be at the Financial Accounting Foundation to be dependable opponents of market values for loans.

In an unrelated event, but telling nonetheless, the Wall Street Journal published a few days later a very perceptive and perspicuous article, by Gabriele Steinhauser, discussing the approaches the EU might take for bailing out Spanish banks. The gist of the article is that "a team of private auditors is rummaging through the books of the 14 largest Spanish banks to determine…" the amount of the loan losses. Nuts.

I recommend that you read the full article, but for the points about the auditors' role that I want to make, it is sufficient to know the following, which in any case is somewhat oversimplified:*

• The European Financial Stability Facility (the bailout fund that is backed by guarantees from the Eurozone member states) will lend €100 billion to Spain for a bank bailout.
• An uncertain amount of the investment, perhaps €25 billion, will be used to capitalize a 100%-owned "bad bank," which will purchase the junkiest of junk loans from the banks.
• The amount not invested in the bad bank will be contributed to those pretty-awful Spanish banks, probably in exchange for some form of TARP-like equity.
• "Each lender's needs will depend on how much it is likely to lose on its part of some €200 billion in loans the banks made to property developers and other boom-time real-estate investors." Presumably, the audits are supposed to help determine these amounts.

I Said "Nuts"

First, whether new capital comes from private or public sources, the valuation question pertaining to an investment should be the same. An investor should want to know how much one could pay for identical or similar assets if they were acquired some other way. Yet, the auditors it seems are not being asked to provide an answer to that question. Instead, they are tasked with estimating: (1) how much cash could be scavenged when (or if) the Spanish economy rebounds within a reasonable time period; and/or (2) the current sales value of the banks' portfolios of loans and abandoned development projects.

Some months ago, I was amused to watch Angela Merkel and Nicolas Sarkozy debating on TV an accounting question: the size of the balance sheet haircut that EU banks should take on their holdings of Greek bonds. Such discussions of paper losses or sale values for asset positions that won't be sold can make for interesting political theater, a play which seems to have been remounted in Spain.

Unfortunately, the real economics of the situation facing Spain and its fellow EU members is much less like theater and much more like surgery without anesthetic. Time marches on and risk is high; hence a simplistic cash-in-cash-out view of gains and losses is far from the transparency that taxpayers, or any other investor, need and deserve before committing one's money to a risky venture that is perilously close to a hopeless cause.

Second, whatever the measurement objective, auditors have no demonstrated competence to produce estimates that policymakers/investors can rely on. If you want a valuation, ask a valuation expert. If you want to understand future cash payment scenarios, then ask an economist. Very simply, and with absolutely no disrespect intended, auditors don't possess the depth of training in asset pricing methodologies or econometrics to do this critical job right – which if not done right could spell the end for the euro.

* * * * *

I see a pattern here. Both the ECB's bailout plan of Spanish banks and the IASB's three-bucket approach to measuring loan carrying values are misguided and inappropriately dependent on the competencies of auditors -- who even with the best of intentions lack the requisite training to evaluate a market value much less an ineffable reserve estimate.

Maybe this is the case study that can convince the FASB that it should leave the IASB and the EU to its own devices when it comes to loan accounting.

It's Crunch Time for Loan Accounting – and Convergence

Once one chooses to ignore market values and to account for loans on the basis of "amortized cost" – as the IASB has "tentatively" concluded and the FASB may now be starting to question once again – the inevitable and ineffable question then becomes how and when to recognize losses on bad loans. Let's examine the alternatives.

The current rules constitute what is known as the 'incurred loss model.' Its only defender in the U.S. is the American Bankers Association, and that should be sufficient to put it to bed. But, if you would like to have the gory details, click here.

The proposed rules are based on the 'expected loss model.' Europeans have taken up its cause, but with apologies to the French and Yogi Berra, it is nothing more than déjà vu all over again. It means that bankers and other financial statement issuers will be required to predict future losses over the lives of loans even in the absence of evidence that a loss has incurred.

As Denny Beresford, former FASB chair once explained in an email to the AECM listserv, one of the important reasons the FASB issued SFAS No. 5, Contingencies, way back in 1975 was to eliminate the practice of accruing "catastrophe losses" in advance of the catastrophe itself. Loans and casualty losses are not the same, but the principle is; and setting aside that principle for loans would not improve the quality of accounting reports from banks any more than that 'cookie jar reserve' accounting was contributing to high quality financial statements from insurance companies before the practice was abolished.

Thus, it warmed the cockles of my heart to read that the FASB and IASB were falling out over the expected loss model. Here is how NYT columnist Floyd Norris called it:

"This week — days after the United States Securities and Exchange Commission made clear it was not going to move toward adoption of international standards anytime soon — the two boards found themselves in angry disagreement over one of the most contentious issues to emerge from the financial crisis: how banks should account for loans that may be going bad [i.e., the expected loss model].

… Leslie Seidman, the chairwoman of the American board, told a joint meeting of the two boards that bank regulators and others had voiced concern about the rules and that she wanted more time to work out guidance and details.

'This is deeply embarrassing,' responded Hans Hoogervorst, the chairman of the international board, which was meeting in London and was linked by videoconference to the American board's meeting in Norwalk, Conn. He said he feared 'this whole thing is going to unravel' after three years of extensive effort." [bold italics supplied]

I hate to be such a spoilsport, but I really hope it does unravel. Very simply, the expected loss model is an even worse solution to the loan accounting problem than the incurred loss model.

Auditing Loan Loss Reserves is a Bigger Problem than Measuring Them

But, the reason I am writing this post is to point out an even bigger problem than the loan accounting rules themselves. The problem I am referring to is that neither mode for measuring loan loss reserves is auditable. Moreover, the problem extends beyond the well-publicized findings of PCAOB inspectors: that many audit firms are incapable of consistently following their own audit programs (see poster children McGladrey, Crowe Horwath and Deloitte).

The mother of all loan loss accounting problems is that, even when auditors do check all of the boxes in their audit programs, they cannot be relied on to make consistent audit judgments.

For example, among the embarrassments to come out of the Greek bond accounting debacle, was the revelation that PwC audited three major financial institutions in Europe that held identical Greek bonds and purported to account for them the same way. Somehow, PwC found a way to conclude that a 51% haircut was reasonable for one client, but a 21% haircut on the exact same bonds was reasonable for another client. Please.

The root of the auditability problem is that management has extremely broad discretion in measuring the amount of impairment, and that auditors are reluctant to challenge those judgments – especially if the client is a too-big-to-argue-with bank. Making matters even more dismal, there is no accounting requirement to refer to current market prices, or even a specific methodology for estimating future defaults. The reality is that so long as an auditor does not object, management can pick pretty much any number it wants. So it does.

 

But, Market Value Alone is Not the Answer

By now, and especially if you are a regular reader of this blog, you are probably thinking that I am going to state that estimated market values can be the only reasonable approach to measuring loans on the balance sheet. Actually … not quite.

In theory at least, estimates of a loan's (or a pool of loans') market should be more "auditable" and "reliable" than loan loss reserves measurements, because an auditor could compare estimated market values to actual market values of traded assets that have similar characteristics. But, my confidence in that theory's applicability to practice was tempered by an observation from Hossein Nouri, when I floated this idea on the AECM listserv.  Hossein wrote, "[T]here are practical limitations to it [i.e., my theory]. For example, for mortgage loans, the banks have hundreds of thousands of loans, if not millions, in different states at different locations. Even within the same city, from one location to another location prices change drastically. In addition, each property has its own criteria, which makes it different from the other properties in the same neighborhood. In sum, there is no easily market value for these properties to come at the fair market value." [italics supplied]

I agree with Hossein that estimates of value are difficult, but it is hard for me to see that they should be more difficult or less accurate than estimates of loan loss reserves. I see the fundamental problem to go beyond the degree of subjectivity in making estimates, to whom is making them.

So, in addition to supporting market value measurement for loans, I go a step further to recommend that loans should be measured by an independent expert – i.e., not management. We need to get beyond the simplistic idea that financial statements should be prepared by management; that's like a student grading herself.

It is time to abandon any notion that management can provide unbiased estimates of value and/or future cash flows, and that auditors are equipped to produce independent and knowledgeable assessments of management's self-interested estimates. The auditor's role in loan accounting should be limited to:

• Verification of the components of financial statements that can be verified (such as contractual amounts and existence).
• Verification of the qualifications of third-party experts charged with estimating market values; and that those experts have performed the procedures they said they were performed.

* * * * *

Loan accounting may well prove to be the demise of IASB and FASB convergence. But whatever the outcome of this project, convergence should take a back seat at the SEC to achieving greater harmonization between accounting and auditing.

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?

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*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.