McKenna at American Accounting Association Public Interest ConferenceBy Francine • Apr 18th, 2011 • Category: Latest, PCAOB, Regulators, Laws, Standards, Regulations, Sarbanes-Oxley, SEC, Where I've Been
The American Accounting Association’s (AAA) Public Interest Section promotes knowledge and responsible action with respect to the role and effects of accounting information and social and ethical responsibilities of accounting professionals.
I presented the luncheon keynote speech Friday, April 1st at the AAA mid-year meeting here in Chicago at the Hyatt Regency hotel.
My speech was entitled, “The Future of the Accounting Profession“. I also participated in a panel discussion on Saturday afternoon, “Defining the Public Interest,” moderated by Professor Patrick Kelly of Providence College.
I’ve reprinted my speech below.
For the panel, I was asked to suggest research topics for accounting and audit academics who are interested in public policy and accounting and audit in the public interest. Get a grant and we can work together!
Here’s my Top X List. For more details get in touch or look around the site for more ideas and starting source material.
Going Concern warnings
- How soon after warning did a Chap 11 filing occur?
- How often do warnings occur outside of annual reporting period? What events precipitate them?
- How many companies survive a going concern warning one year, two years, five years?
- Re the banks – In UK and US, choose the top 20 banks that received bailouts, were nationalized for force acquired at brink of failure. None of them (except Bear Stearns, but it was a retro warning) received going concern warnings the annual reporting period prior to this event, i.e. 2007 and 2008 annual reporting periods. Review criteria for going concern and compare to balance sheets in four last quarterly reports. How many were insolvent or deserving of auditor going concern warnings based GAAS?
Audit firm litigation
- Settlements – examine trend of settlements twenty years (pre-post PSLRA) correlating to largest firms revenues reported, estimated margins. Are firms settling for more because claims are higher or because plaintiffs can squeeze more out of them as firms grew and prospered with lower settlements in lean year?
- Look at the few large cases that went to trial with a judgment against the Accounting firms (BDO-Bankest, PwC Ambassador Insurance). What are factors that cause a firm to go to trial rather than settle since it’s so rare? Do they always lose at trial? Why?
- What is the magic number for a settlement that would be catastrophic to a Big 4 global firm? Does it matter if it is in US or abroad – see EY’s legal troubles in Hong Kong – Some have written it is $1 billion per firm or multiple smaller settlements for less than a billion that come too quickly.
- What is the litigation capacity of the largest four firms based on what we know about settlement patterns, revenues, margins and estimating source of funds and reserves. Look at trend in partner capital contributions, growth of partner numbers, aging population, other sources of capital…
Contingency disclosures and parallel assets – Review disclosures, valuations, reserves
- How often do two public companies in litigation have the same auditor? Are litigation disclosures similar? – Using put-back or repurchase risk and reps and warranties issues as a starter – FHLB vs. BAC and JPM (PwC) , FRE vs JPM or BAC (PwC)
- Same assets on either side of an audit client – PwC and GS vs AIG re: super senior CDS, Repo 105 transaction between Lehman with UBS as counterparty (EY)
SEC sanctions against individual audit partners last ten years.
- Where are they now? Do they stay at their firm? (DiFazio Delphi Deloitte) Move to another firm after sanction is lifted? (BDO partner) Do something else? Start a hedge fund?
- Are the sanctions issued so late after activity that some are already retired? (Bally’s EY) What is deterrent effect? Track impact on audit quality of individual partner sanctions and look at a recidivism rate, if applicable.
- What would the impact of a “known and repeat offenders” list be on the profession? Would there be a deterrent effect? Could easy access to the sanctioned and sued professionals and their location and status help investors?
And here’s the speech I gave on Friday April 1. There were some slides that were displayed at strategic spots. They can be found here.
Thank you so much to Michael Kraten and the program committee for asking me to speak and allowing me the opportunity to participate in this conference. It’s enormously rewarding to me to be here amongst accounting educators with an interest in their public duty and the profession’s activities in the public interest.
My mother always thought I would be a teacher. That’s also a very noble profession. So it’s an honor to be here sharing my thoughts with a group of professional educators in my chosen field. Because as much as I am now a writer and speaker, I am still an accountant and I consider myself a professional.
I’ve worked a lot of different places over the years and I’m no different than you or your students in finding the world we live in a constant professional challenge.
I think your students will face more than one ethical dilemma during the first year of their career at a large public accounting firm or other work environment. In a public accounting firm, which is my focus, the landmines are everywhere.
They may have to decide whether to check a box for a test or review that wasn’t done. They may be asked to create or backdate a workpaper to complete a file before a quality review or PCAOB inspection. They may be pressured to falsify their timesheet to stay under budget for their part of the engagement.
Some will make the right decision and some will go along to get along. This is self-interest and career survival. These are the pressures that chip away, day after day, at their self-esteem as professionals and their ethical resolve.
I graduated in 1984 with a degree in Accounting from Purdue University.
1. My first nine post-graduate years were spent, first, as an internal auditor and financial analyst at the first “too big to fail” bank, Continental Illinois National Bank and Trust of Chicago. Then I worked as a financial reporting manager, G/L manager and Controller in two different B2B industrial distribution companies.
Some of my best “truth is stranger than fiction” stories are from those years and it was during this period that I passed the CPA exam.
2. The next eight years I spent with KPMG Consulting, JP Morgan, and then returned to BearingPoint as a consultant. The last half of this period was spent 100% in Latin America.
3. The post 9/11 years, until recently, were spent at two firms, Jefferson Wells, part of Manpower, as a Regional VP for the Midwest including Toronto, and at PwC, auditing the firm itself.
4. I’ve been on my own now since October 2006, writing re: The Auditors, writing the column at Forbes and writing for others such as Accountancy Age in the UK.
I’ve now embraced another profession – journalism – that has its own list of ethical standards for writers that want to be taken seriously. But journalism is a profession with a voluntary set of standards and code of ethics, not the legally required ones we have to adhere to.
So, what are the standards accounting professionals must acknowledge and adhere to?
First, let’s differentiate between an “accounting professional” and the accounting or audit industry where many professionals practice.
Those of you who are CPAs and teach rather than work in industry can attest that I’m talking about two different things. Accounting professionals work in industry, government, politics, journalism, academia, and other vocations other than a public accounting firm.
What does it mean to be an “accounting professional”?
That’s it. If you work in client service, if you are a CPA, your first obligation as a professional is to your client – not your firm, your partners, or even your family. If your client is doing something illegal, then your obligation shifts to society and to law enforcement. That may seem harsh, but it’s the code that’s supposed to insure that lawyers and accountants, for example don’t cut corners out of their own self-interest and to the detriment of their client’s interests.
Many of you, as accounting educators, send a large number of your graduates, especially your best and brightest to work for public accounting firms.
In the United States, certified public accountants are the only authorized non-governmental type of external auditors who may perform audits of financial statements and provide reports of those audits for public review, submission to the SEC, and to comply with exchange listing standards. In the United States, the firms and their state-certified, licensed professionals are also required to be independent of the entities being audited.
Public accounting is an industry that employs many accounting professionals, as well as lawyers and other professionals. Each group has its own set of standards and a code of ethics. As a regulated industry, all employees of public accounting firms have an obligation to behave within laws and standards governing that industry that are intended to protect investors and serve the public’s interest.
Look at the four largest global public accounting firms. They officially operate as a loose confederation of separate private partnerships for legal reasons and to insure secrecy, but their size and complexity makes them look more like corporations to the outsider. They manage by consensus, but in reality a limited number of partners lead the firm and make decisions on behalf of thousands of “partners” who are more like highly paid executives.
The top four firms generate more than $100 billion in total revenues globally and employ more than 600 thousand people. As auditors and advisors, they work inside the banks, brokerage firms, auto manufacturers, mortgage brokers, and homebuilders. They’re “in the know” about every public company and most large private companies, earning millions of dollars in fees, for audit opinions that, in my opinion, have ultimately proved worthless when it comes to the big financial institutions. Auditors were right there standing by in the boardrooms when the US government took over Fannie Mae, Freddie Mac, Citigroup, and AIG.
They are still at standing executives’ right hands, and also earning more fees helping the US federal government under TARP to organize and control the taxpayers’ new investments in subprime loans, non-liquid assets, and exotic financial instruments. The public accounting firms make money whether companies thrive or whether they fail. The Big 4 firms are now charging billions to advise each other’s clients as those companies file for bankruptcy protection.
Once your students go to work for the firms, they’ll be forced by the reality of auditor litigation, risk, independence, and quality policies, and seeing their firm’s name in the paper more often to think about some serious industry issues:
- Should auditors be immune from liability or accountability for their malpractice and when they’re guilty of aiding and abetting fraud?
- Does the “too few to fail” argument have merit?
- Is it realistic for us to expect auditors to acknowledge a public duty?
- Do audit firms have a right to look after their partners and their profits before the public?
- Do accountants working in for-profit private audit firms feel like professionals?
- Can large audit firms maintain ethical standards, as a firm and as a group of individuals?
- Whose ethical standards should the firm and the individual uphold?
- Does an individual who would otherwise be ethical or at least true to his own values, become compromised once he works for a larger firm?
I believe that a very good discussion of this challenge (larger firms becoming immoral or amoral) is taught in the seminar, “Leading Professional Services Firms, ” in Harvard Business School’s Executive Education program.
You can agree or disagree whether these ideals work when serving multi-billion dollar multinationals to produce the current audit report product. When a professional services firm strays from these principles, it runs the risk of sacrificing values, culture, a code of ethics and the requirement to put the client’s interests above theirs that is inherent in being a firm made up of “professionals”.
A corporate structure, for example, means a professional services firm has to focus on financial results and meeting shareholder expectations rather than meeting partner expectations within the constraints of the values, expertise and professional code of ethics that the firm agreed on when it came together.
Some interesting examples of corporate model professional services firms with varying levels of success are:
- BearingPoint, a spin-off of KPMG,
- Accenture, Huron Consulting, and Protiviti all have an Arthur Andersen pedigree, and
- Resources Global, a spinoff of Deloitte.
Growing too large or acquiring firms that have very different values or culture, even within the partnership model, can also stretch the limits of aligned behavior.
One case that will have a significant effect on how employees of the audit firms view themselves and how the firms view their contribution is the class action in California, Campbell v Pricewaterhouse, a lawsuit about overtime.
Several overtime lawsuits are pending against some of the major accounting firms doing business in California. These suits were filed by non-CPAs, non-licensed associates (entry level college graduates), who believe they were misclassified under California law as exempt professionals and are due overtime and other benefits due to non-exempt employees.
I have mixed feelings about these lawsuits. In twenty-five years of working as an accountant, consultant and internal auditor, I have never been paid time and a half. When you choose to work in a profession, you don’t expect it. My father belongs to three unions and has pensions and generous health benefits in retirement as a result. When I was growing up, as the oldest of six on the South Side of Chicago, his overtime pay as a fireman and bricklayer was what made extras like vacations and college possible. But it was the dream of an easier life for their kids – higher pay for less labor because they had worked long and hard to educate all of us – that drove my parents to give us the chance for a “professional” career.
Many college graduates, these days, don’t see the point in working eighty hours a week during the busy tax or audit season for a fixed salary. When they calculate their hourly rate, even given the fairly generous salaries, signing bonuses, and benefits the best and brightest get as new Audit Associates, many question the total cost of the sacrifices they’re making.
All they see are strained relationships with family and friends, excessive stressful travel, late nights spent performing mind-numbing “monkey work” on laptops, non-stop scanning and photocopying, fewer partners and opportunities for promotion, and very little use of the ambition and brains they thought they were hired for.
It’s no wonder that with the increase in layoffs and cutbacks at the audit firms during the general economic slowdown, when Sarbanes-Oxley work slowed and the financial crisis hit, accountants starting careers in the new millennium have to squint to see the light at the end of the tunnel.
A few states like California, Wisconsin, and Massachusetts – and Canada where similar suits were settled with very little notice here – have wage and hour laws that are perceived as more employee-friendly. Some believe the audit firms are breaking the law in many states by treating non-licensed, non-supervisory, staff as “exempt” from overtime.
The suits are all in various stages but Campbell v. PricewaterhouseCoopers is the fastest moving. On March 11, 2009 a lower court in California court granted plaintiffs’ motion for summary adjudication on the issue of exemption. The judge agreed that the audit associates at PwC in California are not exempt from overtime pay under the 2001 wage order.
But the court noted that the determination regarding exemption is one involving a controlling question of law, that there is substantial ground for difference of opinion, and that an immediate appeal from the order will materially advance the ultimate termination of the litigation. Therefore, Judge Karlton certified the matter for interlocutory appeal pursuant to 28 U.S.C. § 1292.
What all this legalese means is that the plaintiffs and their law firm are winning so far. The Ninth Circuit Court of Appeals accepted the appeal and Campbell will finally be argued today before the 9th Circuit Court of Appeals. The oral arguments will produce a ruling either affirming or reversing the lower court decision. That means either the audit associates will finally win or the issue will go to trial.
The judge, when concluding that “unlicensed accounting assistants do not fall under the learned professional exemption”, made this observation:
The court would be less than frank not to recognize the difficulties this interpretation tenders for some of the employees identified in PwC’s brief. They are not before this court and thus no opinion concerning them need be reached. I note in passing, without intending to suggest resolution of other issues, that at least arguably the work engaged in by the class members is more like the work of paralegals than law clerks.
Does the requirement of a Masters in Accountancy in order to reach the 150-hour CPA licensing requirement in some states negate my assumption of a graduate degree as a sufficient, if not a necessary, condition to be considered a “professional” without a license?
Will universities that provide their states’ CPA hour requirements without the necessity of a graduate degree doom their graduates to status as “para-accountants” until licensing?
There’s an economic argument at play here: In this environment more work produced for less pay is both tolerated by labor and a business model that rewards firms with higher profitability. But there’s also a practical regulatory issue at stake: Can the regulators allow audit firms – who play a role as critical regulatory cogs in the financial system wheel – to delegate more judgment and decision making over financial reporting and disclosure to the lowest level of staff because they are the per-hour cheapest?
If you’ve watched any medical-themed TV show, you know what lack of sleep, overwork, crappy food, and low pay means for emergency room health care delivery. You may also be able to afford the sweatshop approach to media. But can your 401k afford “slave labor” when the product of using the lowest cost labor input is fraud and failure?
Individual assimilation and success in a Big 4 public accounting firm starts with selection based on university credentials, referrals from professors, family background, and business ties, as well as having political beliefs and economic philosophies that are aligned with firm values. This process now starts in some universities in freshman year, with some students having two or three internships before they graduate. For some students it starts even earlier. One or both parents work for the audit firms and the career is one that has always been considered a safe choice. That’s especially true if the apple doesn’t fall far from the tree in talents and personality.
Auditors often marry other auditors or accountants because in school or in their early career they have no time to date anyone else! How many of you married an accountant?
Internal operations of the public accounting firms, especially the largest ones, are conducted in a secretive manner. Financial results and common business metrics are minimally disclosed to the outside and on a “need to know” basis even internally. Once initiated into firm culture, survival requires adoption of an informal oath of allegiance that makes it shameful to betray even one’s deadliest enemy, your competitors, to legal and regulatory authorities. It’s a Big 4 type of omertà, the extreme form of loyalty and solidarity in the face of authority usually attributed to the Mafia.
Examples of an extreme sense of loyalty to even those who’ve disgraced the profession can be found when partners that have been sanctioned by the SEC, forbidden to audit public companies, are later reinstated. Deloitte, for example, kept the partners responsible for Delphi and Navistar on their payroll during their SEC suspension and they survived the sanction to audit more public companies.
Only in cases of potential criminal indictment, such as insider trading or the tax shelter scandals are individuals thrown under the bus by their firms. That’s because the financial and reputational risk to the firms of not cooperating with a Department of Justice criminal indictment is more significant than the cost of defending and typically settling private securities litigation.
Private parties have significant difficulty getting suits against audit firms past the complaint stage to discovery and a trial given the higher requirements for pleading particularity based on the Private Securities Litigation Reform Act of 1995. Particularity means that investors basically have to present, at the pleading stage, hard evidence such as whistleblowers or leaked documents proving complicity in a fraud or deliberate fraudulent behavior on the part of auditors, not just implied auditor fraudulent behavior. Third-party aiding and abetting allegations are not allowed to be made by anyone but the SEC.
In addition, the federal authorities are fiercely reluctant to be the instrument of destruction of another firm a la Arthur Anderson via a criminal indictment or a significant SEC civil complaint. That means the auditors have as much moral hazard now under the “too few to fail” doctrine as the banks have under “too big to fail”.
However, that doesn’t mean the audit firms aren’t faced with an enormous amount of litigation they spend significant time and money fighting.
And we haven’t even gotten started with holding them accountable for their role in the financial crisis.
It’s not easy for an individual external auditor to step up and do the right thing. The model of providing audits, a critical public service meant to protect shareholders via a profit making private partnership, often encourages “behavior that must be regulated”.
The Sarbanes-Oxley Act of 2002 established the PCAOB to replace industry self-regulation after Enron because the public perceived that peer review and self-regulation for auditors of public companies had failed.
Many accounting professionals who work for the audit firms write me in earnest for advice. One of the more common sources of confusion is about their “true client.” They do not know who their real client is. They have either never been taught this concept or had it beaten out of them by the reality of which behavior is rewarded at their firms.
The client for audited financial statements is the shareholder, not the company management. The Audit Committee of the Board of Directors, who hires and is supposed to manage the external auditor, represents that shareholder client but has a legal duty to the corporation not the shareholder. Other stakeholders include bondholders, lenders, employees, vendors/customers who depend on the continued viability of the company, and regulators (whose role is to protect investors and overall capitalist system.)
When professionals forget or suppress acknowledgement of their true client, an auditor loses the ability to properly structure decisions with moral and ethical implications, let alone those with serious legal and regulatory ones. In the face of potential legal implications of a decision, they seek advice from their own counsel in order to avoid liability. In the face of a moral or ethical dilemma, they look at costs/benefits of looking out for the shareholder versus looking out for their own financial self-interest, at an individual and at a firm level.
This is not just my polyanna-ish opinion.
New PCAOB board member Lew Ferguson spoke at an open meeting of the PCAOB last week and explained the disconnect:
What’s also remained the same over forty years is the auditor’s attitude towards investors. Except for a brief period of mutual antagonism after the passage of the Sarbanes-Oxley Act in 2002, auditors behave more than ever as if company management – typically the CFO – is the client with the Audit Committee, rather than investors, now a priority in their “relationship management” activities.
Major investors told the PCAOB that they feel they’ve been left out.
It’s clear to me that auditors demonstrated a profound lack of professional skepticism and professionalism during the crisis. They ignored the possible motives and motivations of their audit subjects.
Rather that assuming management, and possibly the Board of Directors, is self-centered and human, they accorded them the highest form of deference. In the interest of maintaining financial and social relationships, the auditors did not sufficiently challenge and expose survival instincts and financial incentives on behalf of shareholders and the public.
Human beings, however noble, virtuous, and full of integrity in words often fall short in action. We only have to look at the cases of whistleblowers I’ve written about to see how hard it is to step up.
Whistleblowers and those that push unpopular ideas or try to report on wrongdoing often lose their jobs, are vilified by the former employers and sometimes their former colleagues, are often disbelieved and laughed at, attributed with bad attributes and intentions such as revenge, anger, payback, whining, mercenary goals, bitterness, spite, Don Quixote-like tilting at windmills, unreasonable idealism, and impractical expectations.
Whistleblowers are often very right, but often end up being right all alone.
How many times has an external or internal auditor been told when raising concerns or questions about lack of segregation of duties, improper expense reports, lack of proper authorizations for stock options or shady compensation decisions:
“He’s a man of integrity. He lives this company. He is a pillar of the community. He donates to charity. He is an elder statesman of the industry. He has unquestionable, unassailable ethics and cares about this company.”
And maybe they are also told, “How dare you suggest that he would ever do anything to harm his employees, shareholders, business partners…”
Faced with the challenge of questioning someone who everyone else thinks is an icon and may not be, most people back down, question themselves, wonder if they’ve read, seen, or heard what they thought they had. Pressured by the cost of moving forward with potentially imperfect evidence, or with an accusation that shakes the foundations of belief and trust, most “professionals” trust their boss, the lawyers, the advisors, and drop it.
And then there’s the money. Raising difficult issues potentially threatens lucrative business relationships, big deals, or an important promotion. Speaking up can be a career- limiting move, threatening your own livelihood in addition to the success of your office, your practice, and your firm.
But auditors, who are inevitably almost always CPAs, have a higher responsibility. Making the type-two error of being right in your suspicions of illegal activity and potentially enormous harm or loss and not acting on them is completely unacceptable.
Don’t let anyone ever tell you again, after Madoff and the rest of the cases of hubris we have seen during this ignominious year, that any man or woman is above suspicion.
When you’re told, “He’s an icon,” as a professional you should look even harder, be professionally skeptical, trust your own instincts and judgment as long as they have been educated and are competent and objective.
Please teach your students the principle of professional skepticism.
PCAOB Chairman Jim Doty explained this principle at that same open board meeting last Wednesday:
When public accounting firms behave unprofessionally – break laws and compromise standards – the audit industry damages the accounting profession.
The future of the accounting profession is, for better or worse, in the hands of the audit industry.