Thursday, November 09, 2006

Big Audit Firms Release (Self) ''Serving Global Capital Markets and the Global Economy" Report

The CEOs of the Big Four accounting and auditing firms (PricewaterhouseCoopers, KPMG, Deloitte & Touche and Ernst & Young) and two smaller firms (Grant Thornton and BDO International) yesterday issued a report titled, "Serving Global Capital Markets and the Global Economy" (see link here.) The past few years have been simultaneously tough and extremely profitable for these firms, and this report represents a response to the industry's critics. Following age-old advice, these firms apparently believe the best defense is a good offense.

The bad part of the past few years has been obvious: Enron, WorldCom, Parmalat, Shell Oil and a host of other companies were all caught in accounting scandals. In each case, the independent auditors charged with confirming that public companies weren't cooking the books were all found asleep at the post--or worse. Arthur Andersen ceased to exist after the U.S. government brought criminal charges against it for destroying evidence related to the Enron scandal. Italian prosecutors indicted the local branches of both Grant Thornton and Deloitte & Touche as a result of the Parmalat fraud. And, in the United States, the Sarbanes-Oxley Act created a new regulator (the Public Company Accounting Oversight Board) to end the industry's self-regulation.

On the plus side, however, with this new oversight has come record profits. Auditing used to be a loss-leader accounting firms used as a foot-in-the-door to sell big companies much more lucrative management and IT consulting projects. Now, with passage of the Sarbanes-Oxley Act and the new focus on internal controls, auditing has suddenly become very profitable. Particularly since, with Arthur Andersen gone, there's one few firm to compete with.

It is the cost of these auditor fees that is now driving the PCAOB to revise U.S. audit standards. (See here.) Nonetheless, the audit industry is feeling unloved, and "Serving Global Capital Markets" is an attempt to influence the public debate on how U.S. securities regulation might best be reformed. (In this regard, the six auditors join a bandwagon that includes the "Paulson Committee" and the U.S. Chamber of Commerce.)

The report begins, as one might expect, by admitting to, and then downplaying, past failures. "In the late 1990s and earlier this decade, however, in a small, but highly publicized number of cases in the United States, Europe and Japan, certain members of our profession failed to meet the standards of quality that govern our profession." Yes, mistakes were made. But we're all past that now. The report goes on to note how important the audit industry is to the world economy, and how over-regulation of it and its clients might kill the goose that lays the golden eggs.

The report then makes several recommendations, four of which stand out:

  1. The world's accounting and auditing standards need to be harmonized and based on principles rather than rules; and audit industry regulation should be coordinated at the international level (rather than, as is currently the case, effectively dictated at the international level by the PCAOB);
  2. Securities regulations should change so that issuers no longer need to report quarterly financial statements (i.e., 10-Qs and 10-Ks in the United States), but instead should report financial and non-financial information to the public on a "real-time" basis, over the Internet;
  3. Laws governing the audit industry should change so that accounting firms are no longer prohibited from offering consulting and tax advice to their audit clients "in light of the capital markets’ clear interest in assuring the continued attractiveness of the profession and its ability to bring in and retain individuals with the requisite talent and skills"; and,
  4. Auditor liability should be capped in shareholder lawsuits so that audit firms don't go under should they make another Enron-esqe mistake. ("Audit firms and their global networks are not insurance companies. Legal and regulatory systems must reflect this reality. Individual auditors who engage in wrongdoing must be punished but without threatening the financial viability of their firms.")
The first point is a long-standing issue that, to date, has hinged mostly on accounting standards. The U.S. Financial Accounting Standards Board (which sets accounting standards for U.S. companies) and the International Accounting Standards Board (which sets accounting standards for many European companies) have been working together over the past several years to harmonize U.S. Generally Accepted Accounting Principles and International Financial Regulatory Standards. Everyone agrees, in theory, that a principles-based approach is superior to a rules-based approach, but reality has proven less than cooperative. A principles-based approach works only with strong, and fair, enforcement and oversight. Where shareholder lawsuits are a risk, however, rules trump principles -- you can prove to a court that you followed a rule. Demonstrating that you adequately adhered to a principle is more difficult and more open to second-guessing.

But more significantly, the report attempts to link the success of the U.S. GAAP-IFRS convergence project with the far more difficult effort to harmonized global auditing standards. Currently, International Standards on Auditing (ISAs) are a pale shadow of U.S. Generally Accepted Audit Standards (U.S. GAAS), and convergence is a long way off. (At the time of the Parmalat scandal, ISAs did not even require audit firms to confirm that a company's reported inventory existed. In other words, I could tell you that I have a warehouse in Hoboken with $3 million worth of product waiting to be sold, and you would not be remiss in your duties as an auditor if you just took my word for it.) For this reason, pushing for global harmonization of auditing standards -- and global "coordination" of auditor oversight -- could easily be seen as an attempt to weaken the iron grip of the PCAOB.

The second proposal is very interesting. But it is also pretty much a rehash of a proposal put forward by former SEC Chairman Harvey Pitt in 2001. Real-time disclosure of material information to investors would be a great boon, provided the quality and volume of information made available to the market increases, rather than decreases. At the same time, one can easily see how a real-time disclosure regime (particularly one enforced by a strong securities regulator) would be a God-send for accounting and law firms, which would pretty much have to become permanent fixtures in their clients' offices to ensure that the proper information was being disclosed. (The Financial Times has several articles on this proposal, here, here, and here. And given the way Barney Jopson writes, you might think the auditors' report is heralding the Second Coming.)

The third proposal, of course, is a desire to undo the conflicts of interest prohibitions contained in the Sarbanes-Oxley Act so that accounting firms can return to selling their audit clients very profitable management consulting work. However, it was the threat that they might lose such work that led to many of the financial scandals of the late 1990s through Enron and WorldCom. When a client holds out the promise of a multi-million dollar corporate restructuring consulting job, one can see how the pressure would mount on the audit partner to not upset the client with a harsh assessment of how it has accounted for its offshore "special purpose entities". Likewise, if an accounting firm has advised a client on how it should structure a corporate tax shelter, it's hard to imagine that same firm's auditors concluding that its colleagues over in the tax division screwed things up. The idea that accounting firms must be able to offer multiple services to the same client in order to attract bright young MBA and CPA employees properly deserves all the derision I can send its way.

And, finally, the issue of auditor liability is real, even if self-serving. (The New York Times' far more sceptical Floyd Norris writes about that aspect of the report here.) One problem world capital markets face today is that there are only four major international accounting firms left who are capable of offering a major multinational corporation a full multiple-country audit. (It is interesting that the heads of the Big Four pulled in the CEOs from Grant Thornton and BDO International for this report, since concentration in the audit industry is currently a topic of considerable discussion among securities regulators in North America, Europe and Asia. Representing the industry as a "Biggish Six" rather than a "Big Four" might be an attempt to stifle critics who argue audit industry concentration presents a risk to international financial stability and that governments should undertake to promote new rivals.) Consequently, in both the recent ChuoAoyama/PwC scandal in Japan and the KPMG tax evasion case in the United States, concerns were raised that a criminal indictment of either firm might pose a risk to the global financial system itself.

That said, "Serving Global Capital Markets" cannot help but be read as the audit industry's new campaign to limit its liability for future mistakes. The report cites an "expectation gap" regarding what they can do at a reasonable price, and what investors expect of them when it comes to detecting corporate fraud.

"...[T]he “expectations gap” arises because many investors, policy makers and the media believe that the auditor’s main function is to detect all fraud, and thus, where it materializes and auditors have failed to find it, the auditors are often presumed to be at fault. Given the inherent limitations of any outside party to discover the presence of fraud, the restrictions governing the methods auditors are allowed to use, and the cost constraints of the audit itself, this presumption is not aligned with the current auditing standards."

The problem with this view, of course, is that Enron, Parmalat and other corporate fraud cases were not simply matters of an auditor failing to detect an elaborate con perpetrated by evil masterminds. In the Parmalat case, it involved an auditor taking at face value an obviously forged letter purportedly from Citigroup attesting to the existance of an $800 million bank account. (The woman whose signature was forged actually did work for Citi, but apparently as a corporate librarian.) And, of course, while the report focuses on criminal penalties ("It is essential, going forward, for enforcement authorities to focus penalties for any auditor wrongdoing or negligence they may uncover on those directly implicated in such activities, rather than on the entire firms that employ them or with which they may be affiliated"), it is civil liability that is the crux of the matter. While auditors are not insurers against fraud, to argue that they cannot be held accountable for negligently overlooking fraud at the companies they audit is to suggest that their sole role is to check companies' financial statements for typos and math errors. Given that other participants in the global financial market (lawyers, investment banks, brokers, etc.) also face liability for negligence in the performance of their duties, why should auditors be different?

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