The Auditors And Financial Regulatory Reform: That Dog Don’t Hunt

By • May 31st, 2010 • Category: Food for Thought, Latest, Pure Content

It’s not every day that a regular girl from Chicago has a chance to talk with a sitting US Senator about the subject most important to her.

No… I’m not talking about Rosie, my Rottweiler.

I’m talking about the auditors’ role in the financial crisis and their place in the regulatory reform bills now being considered. Through a series of wonderful and kind acts, namely the efforts of one particular journalist, I was invited to talk with Delaware Senator Ted Kaufman (D) and his staff about accounting industry reform.

The conversation was wide ranging and opinions expressed off-the-record. The meeting happened on the same day as Representative Barney Frank’s speech to the Compliance Week conference and we talked about his remarks. I expressed my disappointment with several things especially Rep. Frank’s capitulation on a Sarbanes-Oxley exception for smaller companies and his rambling response to the question about a Department of Justice implied “too few to fail” policy.

The Kaufman team is led with mucho gusto by the Senator. It was great to have a chance to meet them, but I realize it’s probably too late to get anything that addresses audit industry reform in this bill. There’s a lot of compromise going on with what’s already there.

Health care reform took some of the fight out of more than a few on both sides of the aisle and in both legislative bodies. Rep. Frank mentioned it a few times during his speech. He described advantages and disadvantages from a legislative perspective of the pure focus on financial regulatory reform now that health care is “a done deal.” It makes it both easier for media to spotlight an individual politician’s positions without the clutter of other major legislation and harder for that politician to hide behind multiple major initiatives when it comes to supporting or voting for controversial or dramatic change.

I came to the meeting with a few points to make.  I think I did that but, as usual, a discussion of the issues facing the audit industry can get a little depressing, even for me.

However, this meeting, as well as the ones at the PCAOB, made me realize the time has come to make proposals and suggestions for industry change instead of just pointing out the issues, problems and need for change.

Most regulators and legislators avoid talking about wholesale change to the structure of the accounting/audit industry.  It seems too big a task and untenable.  The refrain I hear most often both when attending conferences and events and on this site is, “We can’t get rid of the audit opinion. It’s required.”  I’ve also written about the strong and steady political contributions the accounting industry makes, party-agnostic, dictated primarily by the politician’s position and influence over the audit firms’ interests.

Lack of vision and loads of cash. These are the fundamental obstacles to serving investors and other stakeholders with financial reporting that can be trusted.

But it’s also true that Big Oil has spent years deluding itself and others into thinking that this kind of spill was impossible and that preparing for one wasn’t necessary. Indeed, BP once called a blowout disaster “inconceivable.” Certainly, if you can’t conceive of a disaster, you’ll become more and more lax, more and more reckless, until one happens. You’ll cut corners on backup systems and testing. And you certainly won’t pre-build and pre-position any relevant equipment for staunching the flow. Since a disaster can’t happen, you and your allies in Congress will block all serious safeguards and demagogue all efforts to oversee the industry as “Big Government interference in the marketplace that will raise the price of gasoline for average Americans.”

This quote comes from Salon and refers to the oil spill disaster.  But it could have just as easily been said about the litigation threats against the largest global accounting firms and doubts about their viability and credibility post-financial crisis. If legislators and regulators can’t imagine a world without the audit firms and the audit report in their current form, then they can’t work towards something better for investors and the capitalist system.

The firms are broken and their basic product is worthless. The auditors were completely impotent to warn investors of over-leverage and risky business models, to prevent erroneous and potentially fraudulent financial reporting and to mitigate the impact on everyone of these errors, misstatements, obfuscations and subterfuge by executives of the failed, bailed out and nationalized financial institutions.

It wasn’t such an intellectual leap for media, regulators and legislators to see the inherent conflicts in the ratings agencies’ business model post-crisis and to essentially, with the stroke of a pen, destroy that business model.

New York Times, The Caucus Blog, May 13, 2010: One amendment, sponsored by Senators George LeMieux, Republican of Florida and Maria Cantwell, Democrat of Washington, would remove references to the credit agencies in major financial services laws, including the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Federal Deposit Insurance Act. It was approved by a vote of 61 to 38.

Additional reform legislation sponsored by Senator Al Franken – I kid you not – puts the government in the middle between ratings agencies and the securities issuers. The ideas is to take the “pleaser” part out of how the credit raters make their living.

The Atlantic, May 13, 2010: “The new legislation calls for every new ABS bond issue to have a rating by one agency assigned by a new board, instead of being chosen by the investment bank creating the security. The board will consist of mostly investors along with a few other industry participants. Although the underwriter can solicit additional ratings, it cannot escape the verdict of the assigned agency, so it cannot shop around for whichever agency has the most favorable view.”

Wouldn’t it be funny if the audit firms took advantage of the credit ratings agencies’ weakness and swooped in to do that business?  After all, the auditors have the trust and integrity thing down pat. But there’s no way the audit firms would have the nerve to even float that idea post-EY/Lehman…

Nobody disagrees when I remind them that audit firms have the same inherent conflict of interest as ratings agencies. The audit firms have a business relationship with Audit Committees who are selected by the corporations’ executives.  Audit partners are “pleasers.” The audit fees for the largest financial institutions are in the $100,000,000 annually range but it’s been a challenge to grow that business in the current economic environment. The Sarbanes-Oxley gravy train has pretty much derailed.

Is it such a stretch to think about taking the control over appointment and renewal of auditors away from the corporations – the corporate executives are the true corrupting influence on the poor, innocent auditors –  and give it to the SEC or PCAOB? Corporations could  be required to pay the auditor regardless of the audit opinion or how many exceptions are found or hard the auditor has to push back on aggressive accounting.  All this can happen under the watchful eye of their regulator who can put the firms on a “good list” and can effect limited or general “debarment” type actions if an audit firm or audit partner rolls over and plays dead too often.

I also ran my idea of a Service Corp for Accountability and Transparency by the Kaufman team but I admit it’s a big move.  My basic argument is this:

“Why are the same audit firms who presided over the failure of clients like  like AIG, Lehman, Bear Stearns, Citigroup, Freddie Mac, GM, WaMu, and Wachovia still collecting fees from the survivors owned substantially by the taxpayer? They’re also getting paid by the US government to audit and monitor the bailout programs as well as to audit the agencies themselves such as Treasury. We need to take the audit firms off the taxpayer dole and demand performance.”

Fraud happened and the auditors haven’t even testified before a Congressional Committee.

I went a little further and reminded them that immediate Congressional action will be necessary if the PCAOB is declared unconstitutional by the US Supreme Court. The decision will be made by the end of the month. I hope Senator Kaufman is prepared to help develop new legislation that will reestablish the PCAOB or a comparable regulatory authority within the SEC to continue the independent regulation of the audit firms.

If an emergency bill needs to be passed, let’s take the time to plug not only the gaps cited by a Supreme Court decision regarding Presidential authority but also to fix some other critical holes in the original legislation.

My recommendations for a new PCAOB will be discussed in a separate piece.  Although I am a strong supporter of Sarbanes-Oxley, the law and the PCAOB have been vulnerable to criticism and challenge because of the hasty way the legislation, patterned after regulation of broker/dealers, was enacted.  Given the chance, let’s plug these holes and give the PCAOB the teeth it needs to do its job for investors.

We talked a bit about the litigation facing the firms.   I think the audit firms do a great job hiding the big picture of crushing litigation from everyone, including their own partners.  Suffice to say, I could pick any one of the largest four firms – Deloitte, PwC, KPMG or EY – and make the case that litigation is threatening their viability and their ability to do quality work. Any one of the several billion dollar cases against the largest four global firms may either result in a judgement they can’t pay or require bigger and bigger settlements over and over again in order to avoid public disclosure of their flaws and weaknesses.

The scope of the current audit product – requiring an opinion on the financial statements taken as a whole – means that none of the next tier firms can step up and deliver audit opinions to the global multinationals.  They’re just not ready for prime time. The depth and breadth of their experience is nowhere near what it needs to be to do that kind of engagement.

What the regulators and legislators must avoid is being distracted by the Arthur Andrsen scenario.  The Department of Justice (DOJ) handed KPMG a “Get Out of Jail Free” card after their tax shelter transgressions. Then they implemented, literally and figuratively, a policy to never again indict an audit firm.  What they don’t seem to see is that “too few to fail” is harming investors as much as “too big to fail”.

Moral hazard is moral hazard.

As one of the Compliance Week speakers blurted, “We know now the collateral damage from putting one of these audit firms out of business and no one wants to see that repeat…”

Rep. Frank thinks some version of the Specter bill repealing Stoneridge will make it back into the legislation. I don’t think the Kaufman team agrees. I told them I was in favor of such a repeal since, under PSLRA, judges are letting negligent and corrupt auditors off the hook far too often. It’s easy to bring a suit against the auditors but very hard for plaintiffs to survive a a motion to dismiss, especially when fraud is alleged.  Almost every suit for auditor malpractice or professional negligence settles.  Notable exceptions are BDO Seidman’s loss in the Bankest verdict and PwC’s loss in the Ambassador Insurance case.

It must be confusing when I say the viability of the audit firms is threatened by existing litigation – whether they go to trial or not, settlements and the cost of defense is now suffocating the firms – but I also advocate the repeal of Stoneridge, making the firms potentially even more vulnerable to a catastrophic judgement.

Aren’t liability caps the answer?

No.  That preserves the status quo.

I am advocating we reject the status quo.  The government-sanctioned, oligopolistically priced product – an opinion on the financial statements taken as a whole – should be thrown out and new forms of insuring the integrity of financial reporting imagined.

Ask the short sellers.  They don’t ever take the auditor’s report seriously.  Guys like David Einhorn know when something’s rotten and know to ask the hard questions.

is
Email this author | All posts by

28 Responses »

  1. Sarbanes Oxley (SOX,404,Basel II,Banking & Capital Market Standards IFRS 9,IAS 32 & 39) are all useless.To me if US has to be seen as a Financial Hub/NY as Wall St,Dow Jones,Nasdaq stock market hub of the world.SEC & Obama administration has to do more than just talking,GFC or Banking Crises have shown many loopholes starting from US by Mortgage Crises & hitting the world like fever in 2008.Still the way the things are going i foresee another Recession ( Double Dip Recession)…I have been following BP Spill on US Coast & their executives have no back up plan to cap the oil spill deep underneath the sea surface in Gulf of Mexico…I am afraid it will take 3 months till late Aug to control the oil spill & nothing will be done by US Government.

    Coming back to point Big 4 ,Mid Tier & ohter firms have cases pending on them all over the world in Courts.Francine, i have one question,the whole world has Chartared Accountants (CA) as compared to US Certified Practicing Accountant( CPA)..How does CA designation look upon in US,because i received an email from my US member firm & i was looking at few jobs in NY.They have just revamped their HR Systems ( HR Database)…

    This quote comes from Salon and refers to the oil spill disaster. But it could have just as easily been said about the litigation threats against the largest global accounting firms and doubts about their viability and credibility post-financial crisis. If legislators and regulators can’t imagine a world without the audit firms and the audit report in their current form, then they can’t work towards something better for investors and the capitalist system.

  2. Francine,

    You are truly amazing. You’re tireless in your efforts to bring attention to the need to fundamentally change the audit and PCAOB structures! I get tired just reading all that you do.

    I can’t wait to read your recommendations for new (or improved) structures.

    Thanks for all you’re doing to make a difference in the world.

    Ciao for now,

    Sara McIntosh

  3. I remember bringing up that question during Audit 1 class when I was getting my BS in Accounting. I asked “Doesn’t the fact that the firms get paid for the audit services create some sort of conflict of interest?” All I heard were crickets from the rest of the class. Glad to see I’m not the only one thinking this. Ironically now I’m working Big 4, I wanted to see it for myself, and it more or less confirmed what I had already felt. Won’t be around for long, that’s for sure.

  4. Dear Francine,

    I would suggest that the short sellers like the status quo. They can attain an asymetric information advantage in a world that takes ratings and audits as trusted indicatators.

    Conversely, who has a stake in the validity of the audit? Obviously the owners/shareholders. Unfortunately, most shares are held by institutional money managers who have their own income stream to focus on. I think asset managers embraced Sarbanes-Oxley to the extent that it reassured asset owners that investing in the stock market (and employing them) was ‘safe again’ or ‘still safe’.

    What is the value proposition of your proposal for the shareholder? I would think that anybody would be willing to toss the annual audit, or more accurately the expense of producing it, if it were really a meaningless imprimatur.

    The handful of sites I’ve had a time to look at suggest their Proxies are voted to “enhance the long term value of their holdings”. How do we get them on board?

    https://personal.vanguard.com/us/content/Home/WhyVanguard/AboutVanguardProxyVotingOVContent.jsp

  5. Dear Dave,

    I would agree short sellers probably like a status quo where they can attain an advantage via asymetric information. (I like that word. Have to use it more often.) The ones I know are smarter and faster than the typical investor, even institutional investors, and motivated by having their own money on the line. They are used to playing defense.

    There’s a whole big world of stakeholders who have an interest in the validity of the audit besides pure outside shareholders – employees who invest in the company stock in their 401k, customers, vendors, creditors like banks and bond holders, the community the company lives in and the markets as whole when the company is large enough or strategic enough.

    My rationale for proposing to repeal the government-sponsored mandate for the current incarnation of the audit report/opinion is that it’s too often not worth the paper it’s printed on. For anyone. It’s a meaningless imprimatur but one mandated by government fiat like the stamp you get on your passport when you cross a border.

    How do we get the big institutional stockholders and creditors on board? Give them an alternative that is acceptable to the SEC and other global regulators. Show them how they can get the same level of comfort or less if that’s all they need. For less. Give them a choice in paying for what they find useful and productive. That may be more or less than what auditors provide now. It may be more focused – narrow and deep – rather than broad and superficial. For example, I can’t imagine most wouldn’t pay to have the auditors not weasel out of fraud detection or a timely, true call on “going concern.”

    Thanks for your comments and questions.
    They are a very helpful complement to mine. :)
    fm

  6. Dear Francine,

    Non-auditors like myself will need you to be a bit more proscriptive.

    How are audits mandated? Is it statutory under the 1940 Act or other legislation? If so, we have a useful model in the effort to free investors from the need to buy rated securities. But we rely on you to find our congressiional champion to promote the cause and draft some legislation. From there we can lobby our local representatives to join in.

    You offer some intriguing hints as to what the ‘new audit’ would look like, specifiaclly going concern analysis. Certainly this work is done by management consultants, investment industry analysts and some short sellers. (A lot of short selling – amount unknown by me- is ‘dumb’ shorting based on mean reversion.) How do we marshal it for the wider good? And is it truly in the wheelhouse of the auditor? Maybe I don’t understand fully the term ‘going concern.

    How about this for the ‘free market’ solution. Have audit fees subject to claw back when a 3rd firm finds unorthodox practices. 25% of the fee for each instance of fraud, 5% of fee for non-GAAP practices, etc.

    Dave

  7. Francine – outstanding.

  8. One way of reducing if not eliminate the conflict of interest of Auditors & Clients in Banking & Capital Markets (Financial Services),Asset Management,Insurance,Derivatives,Bonds,Short Selling,Long Selling Securities by Fund Managers & Bond Holders is to appoint by regulator in the country(jurisdication)…I can’t & don’t believe that Big 4 & Mid Tier CA & CPA FIRMS in some jurisdications have conflict of interest ( PWC,EY,KPMG DELOITTE GLOBAL) to name a few.In every country there is a casualty of a Bank or Financial Services institution like Fannie Mac, Faddie Mac in US ( read it in my CFA US Journals).The Audit Quality is another issue which needs to be improved.This has been mentioned by CA Institutes around the world & CPA US Institute.Now let’s have a look at Banking & Capital Market(B&CM) clients:Lehman Brothers,Goldman Sachs,AIG,Bear Stern,JP MORGAN,Morgan Stanley in US,RBS,ABN AMRO in Europe,Satyam,though not Banking & Capital Market Industry,falls under I.T Industry,but the Head Audit Partner & Lead Engagement Partner were part of the fraud triangle…Lihir another casualty of GFC or Banking Crises…
    Referring back or Remember the great article by Francine “World Apart but same issues”….

  9. “Have audit fees subject to claw back when a 3rd firm finds unorthodox practices. 25% of the fee for each instance of fraud, 5% of fee for non-GAAP practices, etc.”

    Or…we can always impose jail sentences for fraud instances. Seemed to have worked before (Enron) and seems to work today (Madoff). Don’t see why someone will think docking audit fees is enough to deter fraudulent, non-GAAP activity.

  10. Dear Francine,

    Since the annual audit is a statutory requirement, any change in the status quo will eventually reqiuire a congressional champion.

    If I’ve correctly interpreted your material, your position is that in the best cases the auditor has been neutered and has lost any credibility as a champion for good corporate practices. In the worst cases, the auditor has been turned into a lap dog complicit in corporate malpractice.

    For the worst cases, I think we will continue to rely on whistle blowers, activists, diligent regulators and insightful bloggers to bring light to shady practices.

    If it is true that the audit has been watered down to mere confirmation of technical compliance, then perhaps a certification like those issued by the International Standards Organization (ISO) could take the place of an expensive audit. Initially the fee would just be shifted from auditors to ISO consultants, but perhaps in year 2 or 3 the cost of ‘re-certification’ would be substantially less. Legislation could offer this path to smaller companies first to help them cut costs and to work out the kinks before taking on more complex organizations.

    Conceivably, this could ultimately solve the paradox of two firms valuing the same security differently by having a committee of the standards organization ultimately rule on the correct valuation rather than the folks desperate to keep the engagement.

    Just trying to help push the rock up the hill.

  11. @Dave aka Sisyphus http://en.wikipedia.org/wiki/Sisyphus

    You have correctly interpreted my material. Neutered, lap dog, impotent, ineffective, complicit… Those are all good ways to describe the auditors.

    The ISO is an interesting actor I had not thought about. But then that’s why I like blogging and receiving comments. People come out of the woodwork or the basement or wherever they have been hiding to think out loud for all of our benefit.

    You have successfully pushed me to write more about this topic. But first I’ve got a post about the new PCAOB I’m working on. It may or may not be necessary based on what the Supreme Court decides but, under the circumstances, it’s time to think harder about audit firm structure and their regulation.

    fm

  12. [...] all the auditors' fault, a line that I note Francine McKenna was (rather naively, in my view) peddling again this [...]

  13. [...] The Auditors And Financial Regulatory Reform: That Dog Don’t Hunt by Francine McKenna in re: The Auditors [...]

  14. Thank you so very much for your work. I’m with Keith – Outstanding. And, thank you for keeping us informed.

  15. [...] Both Congressman Barney Frank and Senator Ted Kaufman responded to questions about the Specter amendment during my visit to Washington DC for Compliance Week's Annual Conference.  House Financial Services Committee Chairman Frank said at the conference that he was in favor of bringing the amendment back in the bill.  Senator Kaufman, although a co-sponsor of the original amendment, is in favor but does not think it's likely. [...]

  16. [...] veto power through their proxy, the SEC, over audit firm inspections.  The passage of the regulatory reform bill gave additional cover for this chess [...]

  17. [...] 3. Campaign candy from K Street. The Big 4 firms spread the wealth on both sides of the aisle in Washington, but the hands out always seem to be the ones with power to effect financial and regulatory reform. Does that reform ever go as far as it should? No. Should it have reached the audit firms at least this time? Absolutely. Did it? No way. [...]

  18. [...] Ted Kaufman, one of the members of the Senate Permanent Committee on Investigation?  I wrote about visiting a Senator to talk about AIG, PwC, and Goldman Sachs. My coverage of Lehman, Goldman, New Century, Countrywide [...]

  19. [...] was neglecting to address important investor issues, including the Supreme Court’s so-called “Stoneridge Decision.” Stoneridge protects Wall Street from “third-party liability” and is one reason why victims [...]

  20. [...] to candidates who were expected to take leadership position after the mid term elections, the Big 4 sought to influence the legislation that became the Dodd–Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, [...]

  21. [...] Ted Kaufmann call the auditors to account now that he is Chairman of the Congressional Oversight [...]

  22. [...] the auditors were left out of the Dodd-Frank Reform Act completely. Their lobbyists succeeded in convincing legislators that, as opposed to ratings agencies [...]

  23. [...] in Washington DC.  This will be my fifth year covering the conference.  There have been many significant stories and scoops for this site as a result of my presence and engagement with the always star-studded [...]

  24. [...] 929Y of the Dodd-Frank Wall Street Reform and Consumer Protection Act mandated that the SEC complete a study to determine, “the extent to which private rights of action [...]

  25. [...] financial crisis related lawsuits, although some key cases were settled early in the process. They escaped any mention in the Dodd-Frank reform [...]

  26. [...] there’s still a long way to go… When I met with Senator Ted Kaufman in Washington DC two weeks ago, I made some recommendations for new legislation in the event the [...]

  27. [...] I met with Senator Ted Kaufman in Washington DC two weeks ago, I made some recommendations for new legislation in the event the [...]

  28. [...] profile of Senator Ted Kaufman in BusinessWeek by Paul Barrett where I was generously quoted led to a meeting with Kaufman and his staff in Washington DC. I had thirty-minutes to pitch my concerns about how the sins of the audit industry during the [...]

Leave a Reply