For those of you that may have thought that my grumpiness may have been tempered a bit by the advent of the holiday season…Bah Humbug!  There is just so much accounting and financial reporting nonsense out there this quarter, that I have been simply overwhelmed by stuffing stockings with lumps of coal for my favorite global accounting firm (GAF) partners, and the humbug large bank clients they serve.

Let’s begin with Jonathan Weil’s recent discussion of Morgan Stanley’s “immaterial” $9.2 billion correction of an operating cash flow (OCF) classification error.  The problem?  Morgan Stanley (MS) accountants didn’t formally restate the Company’s financial reports for the error as required, instead opting for the sleazier “stealth restatement” route on the basis of immateriality.  Where were the auditors?  Well, the auditors actually appear to have discovered this error…my heart be still.  But MS has been “audited” by Deloitte (of recent PCAOB fame) since 1997 according to Audit Analytics.  Why should I be surprised that a GAF auditor actually found something, then looked the other way?  

The U.S. Security and Exchange Commission (SEC) specifically requires that a restating company file a Form 8-K to disclose a restatement.  Also, the SEC’s Staff Accounting Bulletin No. 108 (SAB 108) provides guidance on how the effects of a prior year misstatements (i.e., accounting errors) should be considered in quantifying a current year misstatement.  Finally, the Public Company Accounting Oversight Board (PCAOB) in Auditing Standard No. 6 (paragraph 9) requires that a material restatement be highlighted in the auditor’s report via the addition of an explanatory paragraph.  Well, I guess we now have a better appreciation for why MS opted for the “stealth restatement”…they chose lack of disclosure over transparency.

Before leaving SAB 108, I just had to point out another nugget that may provide some insight into the weak financial reporting practices of MS and other large banks.  Below is an extract from SAB 108’s introductory summary.  Note the highlighted text.

SAB 108 Extract.jpg

This is absolutely unbelievable!  What is even more incredible is that large companies would actually share such thoughts with their securities regulator. If allowing financial statement errors to go uncorrected is acceptable, can outright financial statement fabrication be far behind?  Or are we already there and simply don’t know it?  And if we call out big bank managers and their auditors on such behavior, how long will it be before they assert the Affluenza defense?

But back to cash flows…I was a bit disappointed that Mr. Weil’s article seemed to downplay the significance of OCF in financial institutions, largely on the assertions of the cash flow king, and my idol Charles Mulford.  I beg to differ.  My decades of analyzing distressed financial institutions of all sizes and shapes (as an auditor, acquirer, and researcher) has led me to conclude that OCF can be quite informative in financial institutions, and sometimes even useful in predicting financial distress. OCF capture the realized credit and interest rate risks common to financial firms.  In fact, my PhD dissertation was devoted to this very topic in the thrift industry…I am shocked that Professor Mulford missed this stimulating piece of research…NOT! So, OCF do matter in banks, and MS’s failure to restate properly is a BIG DEAL.

And shouldn’t the public hold financial institutions to a higher standard when it comes to cash flow reporting?  After all, they are the custodians of our hard earned monies, and if big banks can’t accurately report their own cash transactions, why should we believe that they can manage and/or safeguard the funds we entrust to them?  And if you’re thinking that I am over reacting to MS’s isolated “error,” then consider the 2008 restatement by PNC Financial Services which reduced OCF by almost half a billion dollars for cash inflows related to the issuance of perpetual trust securities (clearly a financing activity) in 2006.  The sad truth is that cash flow statement classification errors have reached an all time high according to Audit Analytics (13.3 percent of all restatements in 2012).

One of Mr. Weil’s conclusions on MS’s OCF error could not have been more appropriate, that "the classifications hinged entirely on what was in the heads of Morgan Stanley's executives." That’s exactly why we need more transparency in financial reporting! So management can explain to us what motivated their business decision-making.  And yes, while disclosure rules aren’t perfect, isn’t the “real” problem management’s propensity to engage in deceptive reporting practices that purposefully ignore the intent of accounting rules?  

While I’m on the subject of bank manager intent, I would be remiss in not mentioning the Volker Rule, another well-intentioned attempt to curb bank greed.  Unfortunately, this regulatory intervention also will likely fail given all the wiggle room it potentially provides. How so? Do you really think regulators will be able to verify management intent when it comes to enforcing proposed proprietary trading restrictions?  No way, management will contend that speculative financial instrument transactions are all hedges related to bank positions.  Intent will raise its ugly head again…

Let’s look at a current example of just how difficult it likely will be for us (and regulators) to discern proprietary trading using the GAAP-compliant, and auditor reviewed disclosures related to Goldman Sachs’ recent $1 billion loss on currency trades.  Let’s say we want to find out what really happened here…read the financial statements, right?  WRONG!  Let me show you what I mean…

Goldman Sachs (GS) reported revenues from market making activities of $1.364 billion for the quarter ended September 2013, a decline of almost 50 percent from the previous year’s quarter (10-Q, page 2).  And one major reason highlighted below was a $1.3 billion loss from currencies (10-Q, Note 4).

Note 4 Page 14 10-Q.png

And how did GS explain the loss?  Not very clearly.  The same note indicates that the loss is related to financial instruments reported at fair value.  Additionally, the note seems to suggest that currency loss disclosure is misleading because it is “not representative of the manner in which the firm manages its business activities.”  GS  would rather that we focus on the net “market making” total since “many of the firm’s market-making and client facilitation strategies utilize financial instruments across various product types.”  Okay…I can buy that…so why did market making revenues decline almost 50 percent?  Oh…it was the $1.3 billion currency loss!  Duh, back to the original question!

Note 4 in the GS 10-Q suggests that foreign currency derivative contracts used for hedging were to blame.  So how big is the GS potential exposure at quarter-end going forward?  Of the $1.3 billion in losses, how much was realized (actual cash losses) and how much was unrealized (paper holding losses only)?  All seem like reasonable questions to me…and apparently to other analysts as well.

So let’s continue digging…GS reports a total of $61.5 billion of derivative assets and $48.5 billion in derivative liabilities (10-Q, page 13), over 90 percent of which are over the counter (OTC) traded instruments (10-Q, page 28). This is likely where the foreign currency derivatives in question reside.  And sure enough, according to Note 7 (10-Q, page 29), GS reported a total gross fair value of currency related derivatives of $69.3 billion ($69,229 million not accounted for as hedges plus $44 million accounted for as hedges). Similarly, we find that GS had derivative liabilities of $63.1 billion ($62,972 million not accounted for as hedges plus $135 million accounted for as hedges).  According to the below schedule from the GS filing (10-Q, page 35), the overwhelming majority of these financial instruments were considered Level 2 assets, whose reported values were based on complex valuation models whose inputs according to GS were “verified to market transactions, broker or dealer quotations or other alternative pricing sources with reasonable levels of price transparency."

Note 7 Page 35 10Q.jpg

However, we are not provided any detail on offset amounts related specifically to the currency asset or liability derivatives.  Furthermore, we still have no answers to the currency trading loss issue. Like what you ask? 

Well, first off, how much of the losses relate to financial instrument contracts that no longer appear on the balance sheet (i.e., realized losses)?  And how much of the losses reflect management’s downward adjustment of currency derivative asset and liability values (i.e., unrealized, holding losses) for financial instruments still carried in the balance sheet?

Also, exactly what was the portfolio or risk-based hedging strategy employed by GS that required currency derivative positions (10-Q, page 28)? GS tells us:

The firm’s holdings and exposures are hedged, in many cases, on either a portfolio or risk-specific basis, as opposed to an instrument-by-instrument basis. The offsetting impact of this economic hedging is reflected in the same business segment as the related revenues.

Why was the “hedge” used?  How was it structured?  Was the currency “hedge” considered a success or failure?  When a regulated entity reports losses of this magnitude, such questions are not unreasonable.

And how are we to resolve the apparent discrepancy between the firm’s use of derivatives for risk management (i.e., hedging) in managing its market-making and client facilitation strategies (10-Q, page 14), and its election to NOT use hedge accounting for currency derivatives, particularly those responsible for the huge quarterly loss?  After all, GS did report:

Substantially all gains and losses on derivatives not designated as hedges under ASC 815 are included in “Market making” and “Other principal transactions.

This suggests that GS use of currency derivatives was more speculative in nature, doesn’t it?  

Finally, exactly what market conditions or events prompted the large currency loss?  We need a lot more detail than the generic commentary provided below (10-Q, page 126):

Page 126 MD&A Maket Making Commentary 10Q.jpg

More transparency from GS sure would have been nice.  And the Grumpies actually provided some recommendations over a year ago on how to improve financial statement transparency (see Improving Transparency in Note Disclosures: Can FASB Make the “Hard” Decisions?).  Had GS followed our advice, a reader wouldn’t have had to jump all over the place to find answers, they would have all been in one place.

So, what is one to conclude from all of this holiday season grumpiness?  As management intent increasingly becomes a major driver in financial accounting and reporting, the transparency of business “intentions” is critical.  After all, a lack of complete and transparent information can lead to inappropriate conclusions.  For example, in the case of GS’s recent currency losses, I am left to conclude that they resulted from speculative trading.  And the unwillingness of CFO Harvey Schwartz to provide details on the GS currency positions only adds to my convictions.  Now prove me wrong… give me more transparent information.  Oh, and good luck with that Volker rule thing… 


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


Posted
AuthorAnthony Catanach

Several years ago, the Grumpies were pretty hard on the agencies tasked with enforcing audit quality and ethical accounting behavior in the United States (see Paper Tigers: The U.S. Accounting Oversight Regime).  In that piece, we cited examples:

That accountants can shirk their audit responsibilities to the public with little or no lasting harm to themselves...surely, not as much harm as they caused the investing public. The public should be outraged that not one of these accountants lost their license permanently, and that they continue to prey on the trust of the unsuspecting investor.

But my how times have changed…the “Paper Tiger” has become “Tony the Tiger,” and that is just grrrrreat!

What am I talking about?  Well, it has been a really bad month for the global accounting firms (GAFS).  First, Deloitte gained notoriety by receiving one of the largest civil penalties ever imposed by the Public Company Accounting Oversight Board (PCAOB).  In addition to a $2 million civil penalty, the PCAOB also censured the firm for allowing former partner Christopher Anderson to continue to “practice” while he was suspended by the PCAOB.  According to the PCAOB: 

The Board found that, in anticipation of the PCAOB suspension, the partner was made a salaried Director and transferred to an audit group in the firm’s National Office. After his transfer, Deloitte permitted the suspended auditor to become or remain an “associated person” by engaging in activities in connection with the preparation or issuance of public company audit reports.

Remember, this is the guy who “violated PCAOB standards in auditing Navistar Financial Corporation’s FY 2003 financial statements” and authorized an unqualified opinion (page 3, PCAOB Release No. 105-2008-003).

And what makes this particularly interesting is that Mr. Anderson had his CPA license suspended  by the Illinois Department of Financial & Professional Regulation (see https://www.idfpr.com/LicenseLookUp/disc.asp)  beginning on June 30, 2009.  The Wisconsin Department of Regulation & Licensing also suspended his license for one year until November 1, 2009 (license expired December 14, 2011).  Michigan’s Department of Licensing and Regulatory Affairs was much kinder to Anderson, only fining him $500 (license expired December 31, 2011).  Isn’t it amazing that none of these state regulatory agencies saw fit to actually revoke his CPA license outright?  And despite all of this adverse regulatory action, Deloitte kept Mr. Anderson on the payroll doing “audit related work”…I wonder if they got $2 million worth of value?

Next, on November 6, 2013, the PCAOB took a bold and much needed step by creating a Center for Economic Analysis “to study the role and relevance of the audit in capital formation and investor protection.”  This move suggests a failure by the Center for Audit Quality (CAQ) to provide meaningful or relevant research into improving audit quality.  I am shocked…you mean the GAFS’ blatant attempt to use the CAQ to direct academic research away from real audit quality problems has failed?  Do you really believe that CAQ- (i.e., GAFS) funded research performed by accounting academics can be unbiased?  Not if you want to get more CAQ research funding in the future!  

Think I am being too critical?  Well, just take a look at the quality of the “unbiased research” coming out the CAQ, specifically the descriptive study titled An Analysis of Alleged Auditor Deficiencies in SEC Fraud Investigations: 1998-2010.  If one really wanted to analyze audit deficiencies with the goal of improving audit quality, why would one restrict the sample to 87 “old” cases of alleged fraudulent reporting reported by the Securities and Exchange Commission (SEC), and ignore more recent PCAOB disciplinary orders since 2005?  And what significant insights does this “research” yield?  According to a recent article by Tammy Whitehouse, the study suggests “that auditors faced SEC disciplinary actions primarily related to audits of smaller companies.”  As for the study’s contribution, according to one of the authors:

It’s hard to know exactly what it means, other than it’s not the large multinationals where we see problems.

The implications?  If the multinationals aren’t the problem, then neither are the GAFS, right?  So, was this real research or a CAQ promotion?  Now you can see why the PCAOB’s new Center for Economic Analysis is a terrific development. And it just has to irritate the GAFS and CAQ.  By the way, the CAQ’s Newsroom seems to have missed the PCAOB’s terrific news…I wonder why?

Then, on November 13th, PCAOB Chairman James Doty took another giant step toward GAFS’ transparency and audit quality when he announced at the PCAOB’s recent Standing Advisory Group meeting that it will propose a rule on December 4th requiring public companies to reveal the name of their lead engagement audit partner as part of the annual reporting process. Francine McKenna provides a compelling argument as to why “we deserve to know audit partner names.”  As Francine seems to suggest, would things have been different had the GAFS’ partners been required to sign their audit opinions?  Maybe we should ask Linda McGowan (PwC, MF Global), Chris Anderson (Deloitte, Navistar Financial Corporation), Scott London (KPMG, Sketchers), or Jeffrey S. Anderson (E&Y, Medicis)…

Finally, on Friday November 22nd, the PCAOB again publicly reprimanded Deloitte for its failure to adequately address quality control problems related to its audit practice by releasing the previously nonpublic portions of the PCAOB’s April 16, 2009 inspection report.  And as usual, we see that this audit “emperor has no clothes.”  Is an audit being done in name only?  The PCAOB raised the following serious audit quality concerns in its report (PCAOB Release No. 104-2009-051A):

  • Did Deloitte perform appropriate procedures to audit significant estimates, including evaluating the reasonableness of management's assumptions and testing the data supporting the estimates (page 10).
  • How appropriate was Deloitte's approach in using the work of specialists and data provided by service organizations when auditing significant management estimates (page 11). Specifically, the PCAOB raised questions about Deloitte’s testing of controls and data, audit documentation, etc.
  • Did Deloitte fail to obtain sufficient competent evidential matter, at the time it issued its audit report, to support its audit opinions, specifically as it related to the exercise of due care, professional skepticism, supervision and review (page 12).

What’s really depressing about the these audit quality problems, is that they were almost exactly the same as those noted in the PCAOB’s May 19, 2008 report (pages 12 through 16).  Also, problematic is the waning interest of the popular press in these PCAOB report releases, suggesting that GAFS’ strategy to downplay and even ignore the PCAOB just may be working.

Clearly, the PCAOB needs a bigger stick to whip the GAFS into shape!  Yet, to appreciate just how aggressive the PCAOB has been this past month, just consider how limited its enforcement powers actually are.  According to the PCAOB:

Sanctions imposed by the PCAOB may include suspension or revocation of a firm’s registration, suspension or bar of an individual from associating with a registered public accounting firm, and civil money penalties. The Board may also require improvements in a firm’s quality control, training, independent monitoring of the audit work of a firm or individual, or other remedial measures.

So, the PCAOB does actually appear to be taking full advantage of its enforcement powers.  But I do have one holiday season gift wish…please consider selective deregistration of the GAFS, and not just as it relates to Chinese audit firms.  If the PCAOB finds that the GAFS are effectively ignoring their reports, then just deregister the offending practice offices.  So, if a firm’s recurring audit quality problems are in the City X practice, then deregister that practice. And if City X includes the leadership of the firm, then all the better. I’m not going to hold my breath on this gift wish, and fully expect to get my lump of coal from the GAFS.

But with the holiday season upon us, I am very thankful for the superhuman efforts displayed recently by our resource constrained regulators who bravely battle declining audit quality at the GAFS.  Not grumpy enough for you?  Too bad, best wishes for terrific Thanksgiving Day holiday!

Posted
AuthorAnthony Catanach

 With yields on fixed income securities at or near historical lows, today’s retirees and those planning for retirement are facing major challenges.  Not surprisingly, many individual investors as well as pension funds increasingly are turning to high-yield bonds and bond funds to meet their income requirements. So what’s the problem?  An increasing number of bond funds, pension managers, and other institutional investors are loading up their portfolios with an untested and unproven product about whose long-term performance we know very little:  the event-linked security or catastrophe bond (CAT bond).

We were first warned about the potential pitfalls of these unusual securities back in April 2008, by the Financial Industry Regulatory Authority (FINRA).  But as Ben Edwards of the Wall Street Journal recently has suggested, more investors are being attracted to these investment vehicles given their high returns in today’s low yield environment.  According to Edwards, total returns on these financial instruments were almost 9.5 percent this year, thus swamping investment grade corporate bonds returns of only 1.3 percent over the same period. Is it any wonder that these insurance products are attracting attention?

So exactly what are CAT bonds? They are high-yield debt instruments used by insurance and reinsurance companies, governments and corporations (all known as sponsors) to cover large losses that they might incur from hurricanes, typhoons and windstorms, or natural disasters like earthquakes. These bonds cover major events that are believed to occur once every 100 or 200 years.  CAT bonds allow their sponsors to package such risks into securities which are then sold in the capital markets via structured investment vehicles (SIVs).  And not only do CAT bonds transfer the risk of natural disasters from the sponsors to bond investors, but as with the banking conduits of the financial crisis of 2008, the sponsors need not report SIV assets or liabilities on their balance sheets.  Wow!  History repeats itself yet again on Wall Street…I’m shocked!

Yes, it’s been only five years since we witnessed financial institutions recording over $150 billion in losses for their “off-balance sheet” SIVs.  And now investors find themselves being tempted by another potentially ruinous alternative risk transfer (ART) product. The similarities are frightening: off-balance SIVs, reliance on derivatives, untested asset valuation and loss assumptions, and potentially inflated rating agency ratings. The “frosting on the cake” is just how little we really know about these investments, i.e. the SIVs, their assets, the sponsoring relationships, valuation assumptions, etc.  While regulators and standard-setters have been busy fighting yesterday’s sub-prime lending battles, financial reporting transparency for CAT bonds appears to have been overlooked.  This means that investors may not fully understand the risks they are assuming when they “hedge” the natural disaster risks assumed by SIV sponsors.

Recently, Berkshire Hathaway Inc.’s Franklin “Tad” Montross summarized one significant transparency concern as follows:

The new sources of funds are relying too heavily on catastrophe models in making their decisions about prices…reinsurers and insurers use data and simulations from third-party companies to help assess risk. The models have lent an aura of credibility to pricing…anyone who’s in the industry knows that the models are always wrong.

 Sound familiar?  How big a problem could this be?  Well, the CAT bond market has grown over the last decade with total issuances of over $40 billion and almost $19 billion currently outstanding. And while pension funds historically have been major buyers of these “risky” bonds, high-yield mutual funds (e.g., Pioneer Diversified High Income Trust) also are buying together with money managers, hedge funds, and banks.

To better appreciate the lack of transparency that concerns this Grumpy Old Accountant, a brief review of CAT bond mechanics is in order. CAT bond sponsors rely on offshore special-purpose vehicles (SPVs) to issue these bonds. The SPV is generally considered sufficiently independent that insurers are not required to consolidate the SPV’s assets and operations in their financial statements. Not consolidating benefits the sponsors by reducing their capital requirements and masking the complete extent of assumed risk. In a typical transaction, as depicted below, the CAT bond sponsor creates an SPV, which then issues the sponsor a reinsurance contract for a premium. Simultaneously, the SPV issues bonds to investors. To minimize credit risk for the investor, the SPV invests bond proceeds received from investors in high-quality, short-term securities and deposits them into a security account to protect bondholders, the sponsor and any future swap counterparties. This asset collateralization feature makes CAT bonds just another form of collateralized debt obligation (CDO).

 CAT bond yields are higher than similarly rated corporate securities because the sponsor pays the SPV a premium for its reinsurance coverage. The remaining “normal” return paid to investors is generated by the underlying asset collateral purchased by the SPV.  And to reduce interest-rate risk, CAT bonds generally are structured as floating-rate securities based on a floating-rate index (e.g. LIBOR). This is done using interest-rate swap derivatives. Once SPV bond proceeds are invested and placed with a securities custodian, the cash flows received from periodic fixed dividend and/or interest payments related to SPV investments are exchanged for variable cash flows negotiated with a swap counterparty.

Once the CAT bond sponsor decides to issue these securities, it selects a risk modeling firm to perform a risk analysis and create a loss distribution for the relevant exposure among the various perils and regions exposed. Then, the sponsor works with an investment advisor to structure, design and place the CAT bonds. Once the sponsor has identified the desired protection strategy, the modeling firm and investment advisor prepare securities offering documentation for potential investors. This prospectus or offering circular then is given to the rating agencies who rate the bond. 

According to Reuters, only eight of approximately 200 CAT bond transactions since 1997 have been “triggered,” four from natural disaster losses and the others by damage to collateral from the 2008 financial crisis.  Nevertheless, since CAT bonds are relatively new to the markets, their rating system is less developed than that used for corporate bonds and continues to evolve.  Adam Alvarez, senior vice-president at Bermuda-based insurer and reinsurer Hiscox has warned that:

At some point that good run will be interrupted and it will be interesting to see how these new investors react to the kinds of significant events that these bonds were designed to protect.

 So what are the risks to the investor? Well the most obvious is the loss of principal and future interest if an “insured” event should occur.  The SPV pays the CAT bond sponsor the resulting loss amount from the collateral available in its securities account, and the outstanding CAT bond principal due investors then is reduced by the loss amount. Investors then receive interest for the remainder of the bond term based on the new lower principal amount. 

Also, investors also bear significant credit and liquidity risks. As with a typical bond investment, the CAT bond buyer looks to the debt issuer (the SPV) for timely interest payments and the ultimate retirement of outstanding principal. Unlike a traditional bond purchase, however, the buyer’s sole source of repayment is tied to the SPV’s asset investment decisions.  Therefore, CAT bond investors must “somehow” periodically satisfy themselves that SPV security values are sufficient for debt repayment absent any event trigger.

Investors also face another form of credit risk via the SPV’s use of interest-rate-swaps to manage interest rate risk.  Should the counterparty fail to honor its variable-rate-swap obligation and interest rates increase, the market value of the SPV’s fixed-rate investments will decline, resulting in insufficient collateral to fund future bond retirements. 

Finally, the relative newness of the CAT bond market increases liquidity risk for purchasers. While the interest-rate premium over similar corporate securities offers some compensation for this risk, CAT bond investors must recognize that there may be little or no market for these securities should disposal be necessary to achieve portfolio realignment.

Clearly, CAT bond market participants need information to evaluate both current and future investments. However, current financial disclosures for these debt instruments are woefully inadequate. CAT bonds are generally exempt from registration with the Securities and Exchange Commission (SEC) and its related financial reporting requirements. As the CAT bond investor market grows, so do information needs of the general investing public.  So, specifically what information do investors need?

  • Periodic market-value data to evaluate SPV investments and assess the quality of the underlying collateral for the CDOs.
  • Information to evaluate swap counter-party strength, which directly impacts interest-rate risk.
  • Information to evaluate liquidity risks.
  • Information that provides assurance that CAT bond ratings reflect the risk inherent in these securities.
  • Information on the history and accuracy of models that define loss exposure.

And the need for more financial reporting transparency does not end with the needs of CAT bond investors.  Investors in the sponsors themselves need expanded disclosures for these transactions since the SPV structures are reported off balance sheet. Sponsor stakeholders need information to evaluate the numerous risks (basis, credit, interest-rate, liquidity, systemic and legal) inherent in CAT bond transactions that are currently hidden off balance sheet.  This includes:

  • Transaction volume data the general terms of any outstanding CAT bonds issued by sponsored SPVs, together with historical interest costs, and the current outstanding balance.
  • Information on the SPV assets that are collateralizing CAT bonds to determine whether sufficient funds will be available to honor the sponsor’s reinsurance contract should a triggering event occur. 
  • Information that fully describes the nature of the sponsor’s relationship with the SPV to assess whether off-balance-sheet treatment is appropriate. 

To minimize the likelihood of yet another off-balance-sheet capital market meltdown (once a decade is enough), better information is desperately needed for investors and sponsor stakeholders. 

And I don’t appear to be alone in my grumpiness toward CAT bonds.  As Ben Edwards indicated recently:

To be sure, some market participants are concerned some new investors might not fully understand the risks of buying catastrophe bonds….Swiss Re, a reinsurer, warned last month that this new cash is yet to be tested in the event investors suffer large losses from a natural disaster.

 For those of you that think that CAT bonds are the answer to today’s retirement planning woes, let me remind you of the losses that hammered retiree portfolios in past decades after investing in what then were new and innovative bond investments: high-yield junk bonds and mortgage backed securities (purchased at premiums).

We simply need more information and transparency on CAT bonds…so, retirees beware! 


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


Posted
AuthorAnthony Catanach
CategoriesRegulation

Before you get too excited about the “new and improved” audit report showcased in Michael Rapoport’s recent article titled “How to Make an Audit Report Useful,” I thought a reality check just might be in order.  While the intentions of the Public Company Accounting Oversight Board (PCAOB) and International Auditing and Assurance Standards Board (IAASB) are no doubt honorable in proposing changes to today’s audit report, expanding the report with more accounting jargon is simply not the answer.  

Both the PCAOB and IAASB argue that a new report is needed to better meet investor information needs.  But this begs the question…exactly why are investors clamoring for more information from the auditors about their work?  The answer is simple: audits of publicly traded companies are increasingly becoming suspect as accounting restatements become the norm, and large audit failures far too common.  And it doesn’t help investors when three of the Big Four auditors (BFA) are so deficient in their practices that the PCAOB “sanctions” them by releasing their complete inspection reports.

And if you think that this Grumpy Old Accountant is being too harsh, let’s review some of the “improvements” highlighted in Michael Rapoport’s Wall Street Journal mock-up.

First of all, is it really necessary to define what constitutes a set of financial statements in an audit report?  Hasn’t it always been a fundamental assumption that readers of financial statements have some basic level of financial acumen?  When was that abandoned?  If the “investor” is truly this ignorant, the rest of this “new report” is going to be meaningless.

Next, why are we allowing the BFA to use this new report as a tool to limit their legal liability for doing a poor job?  Consider the following examples/sections:   

  • Stating that the financial statements are the responsibility of company management is uninformative.  If not management, then whom?
  • Also, is it really necessary (and informative) for auditors to clarify their responsibilities, and aren’t they supposed to perform in compliance with the auditing standards? 
  • Do definitions for such terms as “reasonable assurance” and “material misstatements” really belong in the audit report?  The audit report is not an educational tool, but rather an opinion on the quality of a company’s financial statements.

The text associated with the above disclosures serves one and only one purpose: to limit the auditor’s legal liability when audit failures occur.  To assert that these litanies might have any information content for the investor is ridiculous.

Now, there are a couple of sections in this “new report” that actually aren’t bad, but if auditors were really delivering high quality audits, they wouldn’t be needed either.  For example:

  • Information on the conduct of the audit does have some value, particularly given today’s declining audit quality.  But just look at what is being proposed for this section…this is rubbish!  Investors could care less about the organizational structure of accounting firms, or their revenue generation abilities.  Why not tell us about engagement team composition and experience, engagement hours per staffing level, etc.  
  • Similarly, information on audit scope and emphasis could be informative.  But should an investor really have to worry about how the auditors do their jobs?  Why can’t we rely on the auditors’ judgment, professionalism, and ethical behavior to deliver a reliable audit report?

And then there is the “assessment of risks” section.  While this sounds like a nice addition, let’s be realistic.  Are the BFA really going to add any incremental information beyond what is already being reported by a company in the required risk disclosures in the management discussion and analysis (MD&A) section of the 10-K?  I really doubt it…and then there is the other issue.  Do you really think the BFAs will say anything bad about the client that pays their bill?  As for “other audit reports,” why bother?  Auditors are struggling with the basic audit as it is…do we really need more unreliable reports?

So, what do I propose?  Well, as an advocate of the KISS rule (keep it simple stupid), I have a simple solution based on history.  And contrary to Michael Rapoport who asserted that its “pretty hard to ever make audit reports scintillating reading,” here is a report that does just that in only TWO paragraphs.  

We have examined the balance sheet of X Company as of [at] December 31, 20XX, and the related statements of income, retained earnings and statement of cash flows for the year then ended. Our examination was made in accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.
In our opinion, the financial statements referred to above present fairly the financial position of X Company as of [at] December 31, 20XX, and the results of its operations and cash flows for the year then ended, in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year.

Yes, scintillating in its simplicity, conciseness, and directness!  We came, we audited, we reported!  That’s what investors want to know: the numbers in the financial statements are presented fairly.

Where did I get this you ask?  Except for three modifications to update references to changes in financial position with cash flows and the date, this is the standard auditor’s report presented in Statement on Auditing Standards No. 2 in October 1974, issued by the Auditing Standards Executive Committee of the American Institute of CPAs. Yes, a blast from the past, that only an accounting geezer would remember.   As a student, this Grumpy Old Accountant was required to memorize these two paragraphs for his auditing classes.  But for this to work, auditors have to do quality audits!

The issue is NOT the audit report…it’s the audit!  My advice to the PCAOB is to put your head down and keep your eye on the ball.  Don’t be distracted by the politics of the BFA. The audit quality problem will NOT be solved by letting the BFA off the hook with an expanded report that further dilutes their accountability. The audit quality problem will NOT be solved by transferring the risk of misleading financial statements from the BFA to investors via an expanded audit report.  

And a recent survey by the Financial Executives International raises further questions about whether the BFA are being over compensated for avoiding their responsibility.  Is auditor accountability really too much to ask for given the outrageous amounts the BFA are earning for their public company audits? For example, according to Audit Analytics, the BFA “earned” $12.3 billion in audit fees for audits of 6,308 public firms with 2012 fiscal year ends.  And if this doesn’t make your blood boil, just consider how much the BFA brought in for their 2007 audits of firms involved in that year’s market collapse:

 

If the size of the fees and the related abrogation of responsibility don’t bother you enough, consider the following.  For a variety of reasons, the BFA perform substandard audits while engorging themselves with audit, non-audit, and a variety of other consulting fees.  Numerous audit failures and PCAOB inspections are a testimony to their larceny.  And while the BFA continue to grow, investors pay the price.  And many of the laws passed in the wake of the 2007 financial crisis have actually contributed to the further enrichment of the BFA (e.g., Sarbanes-Oxley internal control requirements).  Does this seem appropriate?  And the BFA also continue to lobby legislators to remove or weaken audit quality legislation (i.e., auditor rotation, partner signatures, etc.) proposed after the financial crisis.  A testimony to the strength of the BFA’s lobby is their ability to convince regulators that they are “too few, to fail,” thus insulating themselves from any meaningful regulatory intervention.  And their government mandated charter to audit public companies truly does appear to have given the BFA the “goose that laid the golden egg.”

But let’s not give up on the hope for audit quality and auditor accountability. There IS something that can be done to reign in the BFA’s arrogance, and refocus them on their public duty.  And the solution has been tested numerous times and actually works!  Remember the banking crises of the 1980’s, 1990’s, and 2000’s?  Three decades of “too big to fail” financial institutions spawned an intervention process in which banking regulators assumed control of failing institutions.  Once in charge, the failed “banks” were either liquidated, or rehabilitated sufficiently to be sold.  I propose we do something similar with the BFA… after all, they now are regulated entities right?  Here’s how it would work.

Once the PCAOB determines that an audit firm has not adequately addressed deficiencies reported in inspection reports, the following would occur:

  1. The PCAOB would issue a “cease and desist” order to the accounting firm preventing them from engaging in any new audit business, or beginning any new audits for existing clients.  It would not affect any of their tax or consulting practices.
  2. Next, the PCAOB would assume control of the audit unit of the cited firm using its own inspection staff. PCAOB inspectors would assume control of all audit leadership and administration functions for any remaining audits at the firm, and begin a complete investigation of the firm’s audit business model.  The PCAOB would now run the audit firm.  Of course, the PCAOB would be free to contract with outside professionals to supplement their staffing.
  3. The PCAOB might find that that the audit firm’s problems are isolated to a particular office or regional practice.  In such cases, the PCAOB would require that this unit be liquidated, as previous firm attempts to rehabilitate the practice had not been productive.  Once completed, and satisfied that audit firm problems were corrected, the PCAOB would return control of the audit firm to its partners, and the “cease and desist” order would be terminated.
  4. If the audit firm’s problems were found to be systemic, the PCAOB would begin a gradual liquidation of the entire firm by selling off separate audit practices to interested parties.  During this time period, the PCAOB (and its representatives) would continue to manage on-going audits to their completion.  On an exception basis to minimize effects on the audit markets as a whole, the cited firm might be allowed to continue performing audits for existing clients, but these would be under the ultimate supervision (and scrutiny) of the PCAOB and its representatives. Ideally, this gradual “downsizing” and “cleansing” of the firm would ultimately yield a more appropriately “sized” firm capable of resuming normal operations.  If so, and satisfied that audit firm problems were corrected, the PCAOB would return control of the audit firm to its remaining partners, and the “cease and desist” order would be terminated.

Resolving the audit quality problem requires intense focus, intestinal fortitude, and real imagination.  Unfortunately, the “new” audit report is just a figment of the imagination, and yet another distraction in the continuing battle for audit quality.


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach
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It’s been over a decade, 12 years to be exact, since Isaac C. Hunt, Jr. then Commissioner of the SEC, delivered his seminal "Accountants as Gatekeepers" speech.  Those of you with gray hair (or no hair) will recall this speech for Hunt’s attack on managed earnings and “pro forma” financials.”  In venting his frustration with non-GAAP metrics (today’s descriptor for bad financial metrics), he reminded securities issuers of their responsibilities to “make full and fair disclosure of all material information.” Hunt’s speech is particularly noteworthy as it points out that “federal securities laws, to a significant extent, make accountants the ‘gatekeepers’ to the public securities markets.  

Recently, several articles have appeared in the popular press highlighting “new” ways that companies are reporting performance. In one, “New Benchmarks Crop Up in Companies Financial Reports,” Emily Chasan discusses how some firms are complementing financial reports with nontraditional performance benchmarks. What’s my beef you ask?  Well, my objections this time are consistent with my recent rants about Black Box’s new metrics, and Citigroup’s new performance measurement system.  Simply put, these supposedly innovative and insightful performance measures are neither!  In fact, in most cases, they are quite the opposite, and actually mask real operating performance

My grumpiness on this “new” disclosure business has reached the boiling point.  I am so hot about this that I’m calling out today’s CFOs, as well as the Securities and Exchange Commission (SEC) to stop this nonsense once and for all.  I propose scrapping the SEC’s current Regulation G, which governs the use of non-GAAP measures.  Let’s replace it with a requirement that companies disclose real operating data and metrics, not just financial measures. But there is one hitch: none of the operating metrics I have in mind can use, or be based in any way on any financial statement data, or any combination of numbers that come from the general ledger system!  Let me explain further.

As Ms. Chasan reports, some companies are beginning to disclose relevant operating data, particularly as it relates to customers (e.g., paid membership rates, active users, cumulative customers, etc.).  Unfortunately, many more CFOs continue to try to sell us the same old “snake oil,” namely, “innovative” metrics that are nothing more than repackaged financial statement-based illusions.  You know them well, EBITDA, adjusted EBITDA, and the like. And this deception has continued unabated for years…some of us even remember a wonderful piece by Jonathan Weil titled “Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate.” Nevertheless, the result is the same: financially-based, non-GAAP performance measures that have less to do with the nuts and bolts of daily operating processes, and more to do with today’s troubled accounting “standards.”

Why do so many CFOs promote the use of these non-GAAP metrics?  They maintain that these metrics are needed because financial statements prepared in accordance with generally accepted accounting principles (GAAP), particularly the income statement, don’t provide a complete and accurate picture of a company’s performance. But are CFOs really being driven to more non-GAAP metrics so as to present a clearer picture of the future direction of a business as recently suggested by Professors Paul Bahnson of Boise State and Paul Miller of UC – Colorado Springs?  

What troubles me is that many of these same CFOs are the ones that have lobbied and pushed accounting standard-setters into today’s GAAP.   These CFOs are talking out of both sides of their mouths. On the one hand, they lobby for less restrictive financial accounting standards, then flip on us, to shun the very rules they lobby for as not adequately reflecting their operating performance. Is this complete hypocrisy, or absolute genius?  

Over a decade ago, SEC Commissioner Hunt also criticized CFOs for using pro-forma earnings to describe companies operations as “we’d like it to be”, which always seemed to “paint a rosier picture than GAAP might otherwise allow.”  Isn’t it just amazing that companies which report consistently strong profits and operating cash flows, don’t use non-GAAP measures?  Why is that?  Their strategies are sound and their business models actually work!  So, when CFOs argue for better performance metrics, do they really mean it?  Probably not…if they did, they would stop wasting our time revising, adjusting, and yes, manipulating GAAP financial results in vain attempts to transform these historically-focused performance measures into predictors of the future.  As the saying goes, “that dog don’t hunt, son.”  

While their approach might seem reasonable to some, this grumpy old accountant finds it flawed for one very important reason. Financial statements by their very nature are retrospective, not future-oriented.  In short, they tell us what happened yesterday, regardless of whether they are US or IFRS GAAP, historical cost or fair value.

So what’s the answer to this dilemma?  How can we meet analyst and investor demands for information with predictive value?  The answer to this disclosure need has been right under the noses of CFOs (and regulators) for a quarter of a century: the Balanced Scorecard. This time-tested performance measurement framework encourages managers to supplement their financial metrics with forward looking non-financial metrics. One defining characteristic of these forward looking metrics is that they cannot rely on, or be derived from financial statement data.  Rather, they are based on non-financial operating data generated by a company’s business model and related processes.

If the Balanced Scorecard is so wonderful, why haven’t CFOs widely embraced it?  After all, it is widely claimed that the CFO’s role has shifted to a more strategic focus (from accounting and reporting) over the past decade, especially in large firms.  Why are these strategy-driven CFOs still so consumed with financial metrics, rather than the Scorecard?  There are a variety of reasons, and they won’t surprise you.

Could it be ignorance?  Surely not, after all today’s top CFOs come from top MBA programs where the Scorecard is a staple of the required performance measurement course.  So why is there this disconnect?  While CFOs may be aware of the Scorecard, they just might not understand their business models very well, particularly given the shift in their backgrounds from accounting to strategy. Without a detailed knowledge of a company’s operations, meaningful non-financial metrics are not possible.

Could it be laziness?  Absolutely, particularly since constructing effective non-financial measures is challenging, especially in a dynamic business environment characterized by transaction speed and complexity.  Then let’s add to this the short-term performance horizon of today’s CFO.  Do we really think they are willing to invest the time and energy to create “real” performance metrics if they plan on moving on to another “opportunity” in a couple of years? 

Or could it be something more sinister?  Maybe the zeal to transform weak GAAP results into something more positive is simply the need to increase investor expectations and stock price.  That’s where I would put my money: greed and the intent to deceive.  But then again I did love the X-files...

So what’s my solution?  Well, as I indicated earlier, let’s start by having the SEC scrap Regulation G.  Next, ban ALL non-GAAP metrics in all securities filings.  Let’s eliminate non-GAAP, “everything but the bad stuff,” disclosures once and for all. This would mean that ALL financially related disclosures (including ratios) would be based on GAAP.  If analysts feel that GAAP numbers need to be adjusted for some reason, let them do it themselves.  Yes, I recognize the sell side analysts might need some help given their generally weak accounting skills.  

But what about analyst and investor needs for predictive information?  After revoking Reg G and banning non-GAAP measures, I would urge the SEC to permit and encourage companies to report non-financial metrics consistent with the Balanced Scorecard’s learning and growth, business process, and customer dimensions.  For example, CFOs could address such questions as:

How well are company investments in technology, people and other resources performing?

How well is a company’s business model performing (market analysis; R&D; sales and marketing; procurement, production, and distribution; and after-sale customer service)?

How much do a company’s customers appreciate its product and/or service?

Now remember, none of the above metrics can rely on or be computed using any financial accounting data from a company’s general ledger that ultimately makes its way to the financial statements.  These new metrics must come from data generated from a business model’s operations. This should not be a problem in today’s “big data” world.  And even small companies have access to inexpensive tools to collect such data.  

My proposal offers a win-win situation for everyone:

First, analysts and investors get the predictive information they need given the required non-financial nature of the metrics.

Regulators no longer must police filings for adjusted EBITDA and other “flaky” non-GAAP metrics.

Large accounting and consulting firms get new revenue opportunities (i.e., the next wave) as they install new non-financial reporting systems using “big data.”

Strategy-focused CFO’s no longer have to feign interest (or knowledge) about accounting numbers.

However, there is one party disadvantaged by this grumpy suggestion: the popular press.  Journalists will lose non-GAAP metrics as fuel for future articles, thank goodness.  No longer will we have to listen to or read about how these perverse financial distortions are new, innovative, and meaningful.  I vote for that!

 


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


Posted
AuthorAnthony Catanach
CategoriesRegulation