Wednesday, September 20, 2006

An American (inspector) in London

Speaking of the extraterritorial reach of U.S. regulators (goooooo, Empire!)... One of the things that has the UK folks upset these days (in addition to the NatWest Three, and our beloved president referring to Tony Blair as "Yo, Blair!") is a recent inspection by the Public Company Accounting Oversight Board (PCAOB) of the London offices of the accounting firm Ernst & Young. (See Barney Jopson's "US inspectors scrutinise E&Y in London". I particularly like his opening paragraph describing it as "the latest case of US regulatory 'creep'".)

Don't get me wrong--I'm all for extraterritoriality. But I fail to see how this lives up to my high standards of reaching across borders to impose your rules on someone else. I also don't see how this is news.

For one thing, this isn't about imposing U.S. regulations abroad. Basically, following the Enron, Worldcom, Adelphia, Tyco, and Xerox debacles--and before the Parmalat, Royal Dutch Shell, Ahold and other debacles that didn't actually happen in the United States--the U.S. Congress decided we needed some kind of oversight body to regulate the auditing industry. In each of these scandals, financial problems had gone undetected by these independent auditors charged with making sure a company's books are accurate. Hence, the PCAOB.

The Sarbanes-Oxley Act (yes, I do live and breathe SOX these days) says that if you are going to audit the financial statements of a company listed on the U.S. market, you have to be registered with the PCAOB. And if you are registered with the PCAOB, you have to be open to inspections by it. However, most big companies don't operate in just one country. And not all companies listed on U.S. stock exchanges are based in the United States. In both cases, part of the company's operations are overseas and those parts must be audited as well if the company's financial statements are to have any meaning.

This gets tricky here because most countries have laws that say you can't be an accounting firm in that country unless you have a license there. So big accounting firms like Ernst & Young have local "partners" or "affiliates", licensed locally, that audit the financial statements of the local part of the U.S.-listed company.

How does a regulator ensure that the audits of the foreign subsidiaries of a company are thorough and not undermined by conflicts of interest? There currently are two different approaches. (Well, three, if you count "we don't care" as an approach.) The first (and most common in Europe) is to hold the "lead" auditor responsible for the entire audit. If the local auditor screws up, the lead auditor takes the hit. The problem with this approach is that if liability rests entirely with the primary auditor, there is no way that auditor will permit the company to use any other local auditor than the one it is affiliated with. Why should it? At least it has some control over that guy. This can create problems of competition, particularly since there are only four big audit companies in the world, and not all of them operate everywhere.

The United States takes a second approach--every audit firm is liable, but only for that portion of the audit they conduct. The only way this approach works, though, is for everyone to be subject to PCAOB oversight.

Some of the UK folks over at E&Y apparently are complaining that the PCAOB inspections are duplicative of what the UK authorities already do. This is partly disingenuous. U.S. Generally Accepted Auditing Standards are different than those used in the UK and the EU, so the inspections can't be entirely duplicative. Second, these kinds of cross-border inspections are not unique. The SEC and UK FSA currently conduct joint inspections of investment advisers operating in both the U.S. and UK (as mentioned here, in a speech by Ethiopis Tafara of the SEC).

So, is this an example of U.S. "regulatory creep" or "British firms under US rules" (as Steve writes at the Pub Philosopher)? Or is this just U.S. rules for U.S. markets in a world where firms don't recognize the niceties of borders?


Toby Lucich said...

Well put. I too expect "assurance" work to fulfill this need - to offer shareholders comfort that the financial reports in fact have integrity.

Where is the value for an international public company serviced by a series of external audit offices on a single engagement, all reviewing by a very different set of auditing standards?

M.D. Fatwa said...

That is actually very close to what happened with Parmalat. Grant Thornton's Cayman Islands affiliate showed a standard of care that was "sub-par" to say the least, but the image projected by the financial audit was one of complete confidence.