Re:Balance -- Jim Peterson

Re-Writing the Auditor's Report -- The Financial Reporting Council Swings a Two-Edged Editorial Sword

2013-06-17T10:49:06-05:00

Twas brillig, and the slithy toves

Did gyre and gimble in the wabe:

All mimsy were the borogroves,

And the mome raths outgrabe.

How fitting, that the Victorian era in which the independent auditor’s report was invented also brought forth Charles Dodgson’s unique combination of mathematical genius and – as Lewis Carroll of Jabberwocky – his verbal acrobatics.

So I thought, reading the new language requirements of the Financial Reporting Council, the British audit regulator, in its revised ISA 700, “The independent auditor’s report on financial statements”.

Life was once so straightforward. In the 19^th century, Mr. Deloitte’s pioneering report on the half-yearly accounts of the Great Western Railway at December 31, 1850 read, in its crisp entirety, “Audited and approved”.

This month, while the Public Company Audit Oversight Board in the US, the European Commission in Brussels and the International Auditing and Assurance Standards Board on the global front continue mired in endless projects aspiring to evolve the standard report, the FRC’s vorpal sword has gone snicker-snack.

It strikes one successful blow, at least – against one of financial reporting’s great historical opacities. The new British ISA requires that the audit report’s description of the assessed risk of material misstatement must:

“Provide an explanation of how the auditor applied the concept of materiality in planning and performing the audit. Such explanation shall specify the threshold used by the auditor as being materiality for the financial statements as a whole…” (emphasis added).

It has forever been a mystery why financial statement users have tolerated a reporting and assurance model, the scope of which is designed “to give reasonable assurance that the financial statements are free from material misstatement…”, without a clue from either issuers or auditors as to the magnitude or contours of the term “material.”

At last bringing sunlight and transparency to the question of “how big is big?”, the ISA invites specific amplification, for example, of categories of items having lower materiality levels, materiality thresholds for reporting unadjusted differences to the audit committee, and qualitative considerations relating to the auditor’s evaluation of materiality (¶ A13B).

In the disclosure-oriented environment of the American securities laws, it would seem plain beyond ambiguity that putting such information in the hands of investors is to welcome them into the circle of the better-informed – with, no small matter, a concomitant imposition of responsibility for their own absorption and analysis of the information.

That’s on the plus side. Not so promising, the requirement that an unqualified auditor’s report – which must “clearly state that the financial statements give a true and fair view” (¶ 18) – explicate the assessed risks, materiality and audit scope, in language that must be “related directly to the specific circumstances of the audited entity and … not, therefore, generic or abstract matters expressed in standardized language” (emphasis added).

Charles Dodgson may have been able to integrate quantitative and verbal competence back in 1872. But expecting linguistic agility from today’s number-crunchers is a stretch too far.

For proof, the FRC’s own admonition on risk disclosure (¶ 19(A)(a)) is a sufficient example, as it stumbles in ponderous violation of the norms of style, punctuation and syntax:

“Describe those assessed risks of material misstatement that were identified by the auditor and which had the greatest effect on: the overall audit strategy; the allocation of resources in the audit; and directing the efforts of the engagement team…”

A better idea would be to tap the centuries of exquisite poetry and soaring rhetoric in the country’s grand verbal heritage. The phrase “true and fair view” has always seemed, after all, to resonate in its English-ness – as if any issues of clarity or sufficiency should be subject to gentlemanly resolution on the playing fields or over brandy and cigars in the lounge back at the club.

So here would be a few precedential examples for a descriptive accounting and audit vocabulary in non-generic, non-standardized terms:

On the deferral of executive incentive compensation: “The rule is jam tomorrow and jam yesterday but never jam today.”

On the difficulties of a protracted corporate reorganization: “Now is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

On the impending threat of a bankruptcy filing: “It was a dark and stormy night.”

On the choice of aggressive accounting principles by which to value a derivatives portfolio: “I know a bank where the wild thymes blow.”

And, perhaps best of all, on the possibility of a going-concern qualification: “To be, or not to be: that is the question.”

Readers are invited and encouraged to bring forward their own suggestions.

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Tired Old Boys' Clubs -- A Lesson on How the Eras End

2013-05-29T10:51:29-05:00

Can a long-vibrant institution be kept alive – however steeped in tradition and a long history of value to society – when it falls into terminal decay? Should it be?

My recent travel for the graduations of two young friends, to a city dominated by its colleges and universities, meant a scramble for lodging – eventually solved by scrounging a comfortable but well-worn guest room in an old alumni club.

Regular readers familiar with my concern (see here, here and here) for the survivability of the Big Four’s franchise to deliver audit services to the world’s large companies – an invention of the Victorian era and basically unevolved since – will recognize some lessons in the death spiral of this 19^th century landmark, now fallen to seedy and tattered gentility:

What happens to a resource -- once grand, respected and important -- but now clearly of faded glory and on its last legs?

Designed and purpose-built as a private club by architects of world renown, this institution stood proud witness to the Gilded Age, populated by men of stature and significance:

Tons of marble, forests of hardwoods and acres of oriental carpet were assembled into brahmin luxury – sadly now dulled, dusty and threadbare testimony to by-gone times.

Among the eccentric anachronisms in the entrance foyer are carved wooden indian busts, towering grandfather clocks, and the battered bronze gate on the ancient elevator that could have been installed by Otis himself.

Aside from a bare-bones website, “information technology” consists of reservations hand-written on a stack of file cards.

The limited “scope of services” reflects unchanged priorities – an unused billiards table in the bar and a tuneless grand piano in the parlor, instead of the demands of today’s young professionals for an exercise room, a swimming pool, and a media center complete with juice bar.

During my stay I had a choice of empty rooms in which to establish a virtual working office. The club has so little cachet that it does not even attract members to post-lunch naps in the deep leather chairs of its reading room.

On a daily basis, dining and meeting venues are ghostly, echoing with the footsteps of a diminished skeleton staff. Friendly as they are, the kitchen is closed on weekends, there is no newspaper delivery, and party leftovers go uncleared until the arrival of the Monday crew.

The club survives not on the custom of its elderly and steadily diminishing membership, but on outsourced catering for wedding receptions and other rituals, for strangers whose ethnic names and lands of distant origin would have meant instant blackballs had their grandfathers been so foolish as to apply for membership.

The club’s contentious struggle over the admission of women came to a formal end decades ago – grudgingly, as shown by their then-required use of the side entrance rather than the front door. Even today, the true degree of gender balance is revealed in its governance: the only board committee listing more than one woman member is Decor.

On the financial side, the members have burdened themselves with a multi-million dollar mortgage on their historic clubhouse – a deadly strangulation of debt that cannot trace to the prosperity of its founding generation. This looming threat to solvency most likely arose from the unavoidable costs of essential if long-deferred maintenance, building code compliance, and the rapidly escalating property taxes in its pricey neighborhood.

As for the future, when the denial finally ends and the doors close on the club’s unsustainable model? Institutional memory will dissipate. The handful of users will disperse to modern alternatives with only a brief spasm of nostalgia. The archives and artifacts will be auctioned off for trivia.

Sale of the building will generate a one-time windfall to be fought over with the passion of the depleted. It will be paid in by an investor looking to a newly-designed future – a twenty-something new-media billionaire or the sovereign fund of an oil sheik – who will overcome furious if futile neighborhood opposition and install an amenity-laden boutique hotel.

The parallels of this poor failing club to the exhausted state of the Big Four audit franchise are many and clear: limited service offerings unchanged since the 19^th century, an obsolete organizational and operating model ill-suited to current competitive demands, and inflexible financial fragility exposed to fatal external shocks.

With the students in my graduate-level course in Risk Management, I would assign this exercise in extended metaphor as overnight homework. In the academic spirit of the graduation ceremonies that underlay my traveler’s experience, I invite readers here to do that for yourselves.

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KPMG's Independence, Herbalife's Stock Price, and the Game of Name Blame

2013-04-11T16:22:23-05:00

What does this say about the value placed by investors on the independence of outside auditors:

Two trading days after KPMG withdrew its audit reports on the financial statements of its Los Angeles clients Herbalife and Skechers, because of inside information shared by its promptly sacked and criminally charged engagement partner Scott London, the stock price of both of those stocks has actually risen!

The consequences of London’s passing on, to the million-dollar benefit of his golfing pal Bryan Shaw, will be swift and nasty:

Ratted out by Shaw, London will cut the fastest plea deal the prosecutors will offer.

KPMG will hurl its checkbook at every dollar of costs incurred by its ex-clients to obtain replacement auditors.

Aggressive plaintiffs’ lawyers will fashion some theory of shareholder harm – despite the stock price upticks – doubtless spinning a conspiratorial connection with the long-running spat over Herbalife between raider Carl Icahn and shortseller Bill Ackman, and eventually coercing a nuisance-level settlement.

And the American securities and accountancy regulators – the SEC and the PCAOB – will vie with each other in a pell-mell rush, recalling the unseemly post-Enron haste with which the Sarbanes-Oxley law was passed in 2002, to push a requirement that auditors of US public companies identify by name their partners signing client audit reports.

This last has been opposed with intensity by the American accounting profession, although long in place in much of the world without measurable adverse effects.

Nor, it should be noted, with measurable benefits either – as client managements and audit committees in the US have never lacked access to the decision-qualifying information necessary about the engagement personnel at their audit firms.

In the wishful search for magic bullets aimed at the structural weaknesses in the auditor-client business model, “partner naming” is a distinctly small-bore and ineffective weapon.

But London’s downfall does require re-framing my opening question, this way, heretical as it may seem:

What value to the operation of the capital markets – if any -- is actually delivered by the entire structure of auditor independence?

London’s professional position was destroyed, and his liberty put in jeopardy, not because he violated the elaborate dictates of the auditor independence rules, but because of his multi-year violations of the insider-trading prohibitions of the American securities laws.

And on the other hand, despite KPMG’s immediate and apologetic resignation and report withdrawals, the stock market has given credence to the assertions that the substantive content of the Herbalife and Skechers financial statements are unaffected (even given the charges hurled in the Icahn/Ackman dust-up).

In short, the indifference of equity investors to the state of KPMG’s independence speaks volumes.

I’ve long been saying (here and here) that – under the “client pays” business model for financial statement assurance, invented back in the Victorian era – the accounting profession has gained nothing positive for years, by way of reputation, stature or risk and exposure mitigation, from the intellectually unsatisfactory edifice of “appearance of independence.”

Now, the stock price non-event of Scott London’s misadventures equally shows the converse – that investors impose no downside price penalty on even a slam-dunk independence violation.

Conclusion: the time, energy and cost of maintaining the outmoded and anachronistic structure of “independence” should be re-directed to the long roster of topics legitimately worthy of the effort.

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