Edith Orenstein’s FEI
Blog is a vital resource on the antics in Washington affecting the
financial sector. It was my pleasure and privilege this week to offer this
guest post:  

“Audited and Approved”

Opinion of William Welch
Deloitte dated 8^th February 1850, on the half-year accounts of the
Great Western Railway as of December 31, 1849, in its entirety

It's been downhill for auditors' reporting ever since.(1)

Public Company
Accounting Oversight Board (PCAOB) chairman James Doty described the changes proposed on August 13 to the long-standard auditors’ report to “mark a
watershed moment.”

The releases from
the large firms ranged from the straight-forward (PwC)
to the enthusiastic (KPMG), with the expected cheer-leading coming from their flacks; muted criticism from Tony Catanach’s Grumpy Old Accountants and the corporate bar; along with a predictable flag of litigation
risk from the Journal of Accountancy. 

With formal
comments due to the PCAOB by December 11, and as the polite applause dies down,
a cooler perspective should see this tinkering as no more a “game change” than
raising the stakes from a penny to a nickel.

That’s because the
PCAOB is playing it small all the way. Board member Steven Harris emphasized “the need not to change what auditors do, but
to change how they report what they do” (The emphasis is his, not mine). Board
member Lewis Ferguson concurred, noting that “the standard does not require the auditor to do any
additional work.”

To focus on what
auditors currently do, however,
misses entirely the point of investor concern. The famous and misunderstood “expectations
gap” has never been about what
auditors do. The gap does not even exist, in the minds or the behavior of
investors until it bursts forth after a major corporate fraud or failure.

Unfulfilled auditor
“expectations” have emerged with every outburst of serious issuer performance,
from McKesson&Robbins in 1940 to JP Morgan Chase’s “London Whale” today.

“Where were the
auditors?” does not concern transparency or the disclosed detail of audit work,
but the perceived dereliction of not detecting or preventing a manifest problem
– whether the collapse of Enron Corp. or the thievery of Bernie Madoff.

Investors are not
demanding more nuanced wordsmithing about, for example, the auditors’ attention
to issuer information outside the financial statements – the impossibly elusive
articulation of a distinction between “read and consider” and “read and
evaluate.”

What they do want
are answers to share price-moving questions that neither the auditors’ work nor
the PCAOB’s changes can ever hope to reach. They include questions like these:

• Will a particular pyramid-structured company
  – Herbalife comes to mind — turn out to be a Ponzi scheme?

• Can a particular company whose customer base
  is concentrated on a high-tech device – Blackberry, perhaps — actually survive
  in a world of fast-paced and constantly evolving competition?

• Which financial institution will suffer the
  next rogue trader at its derivatives desk? 

Since securing the
franchise to provide financial statement assurance for public companies, under
the American securities laws of the 1930’s, the accounting profession has borne
self-inflicted responsibility for the creation and expansion of the
“expectations gap” – by such actions as:

• Over-selling the level of comfort its
  reports convey – going back to the inference of guaranty conveyed by the
  unfortunate and now-replaced terminology, “auditors’ certificate,” and the
  profession’s futile inability to escape its lingering shadow.

• Tolerating the misplaced label of
  “watchdog,” as applied by jurists and academics whose presumption of guidance
  exceeds their competence to pronounce.     

• Fostering the obsolete and intellectually
  fragile “appearance of independence” – a trope at odds with the “client pays”
  model in place since Mr. Deloitte’s era, which delivers neither protection for
  the auditors themselves nor enhanced comfort to users.

One thing is for
sure – the PCAOB anxiety about creating a bull market in boilerplate language
is well founded. Defensive file-stuffing will prevail, as the Big Four prepare
for the double-layered second-guessing in their future PCAOB inspections. Not
only “Why was this issue not deemed a ‘critical audit matter’?” – but also “How
did you decide that this ‘critical’ matter did not require disclosure?”

So it may
be safely predicted that every Big Four client will have some minimum number of
“critical audit matters.”

Moreover, similarities
across sectors and industries are far greater than individual differences
between companies. Every bank has issues with provisions for non-performing
loans. And the entire technology sector has been challenged by revenue
recognition in all the years since IBM pioneered its manipulation.  So the pick-list of those items will
quickly become standardized.

What is dispiriting
is that, on such significant issues as those in the recent great collapses –
think Bear Stearns and Lehman Brothers and Merrill, MF Global and Knight
Capital and SAC —  it is right to
question whether auditors might have contributed positively — by way of targeted
scrutiny and assurance – to management, boards and investors alike.

But it couldn’t
have happened, and won’t — not under the small-bore thinking of “no more work
– only more words.”

And not so long as
the assurance model is hostage to today’s binary “pass-fail” report –
accurately described by PCAOB member Ferguson as something at which “they
merely glance … to make sure that the opinion is unqualified….”

If anything good
emerges, it is the end of the endless discussion of mandatory auditor rotation
– a majority of the Board now accepting the absence of data even suggesting a
relationship between auditor tenure and audit quality.

In a one-sentence summary – which propriety inhibited
me from sharing with Ms Orenstein’s readers — the PCAOB has acted on this one
like the little boy in church, losing bladder control in his dark blue suit:
the results don’t show very much, and he gets to feel relieved and warm all
over. 

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1. Until supplanted by an earlier-dated
example, this pioneering statement – which I found hiding in plain sight in the
National Archives of Britain in Kew, on the outskirts of London – is the first
expression of independent assurance by one of the profession’s founders, on the
financial statements of a large publicly-held corporation.