The American Airlines - US Airways tie-up smacks of the last two singles shacking up due to expediency rather than out of love.
— Thomas C. Lawton, March 1, 2013, US News & World Report

The recent U.S. Department of Justice challenge to the proposed merger of American Airlines and US Airways (US Air) nudged this Grumpy Old Accountant to see what all the fuss was about.  Critics of the deal argue that the combination will reduce competition and choice, and also lead to higher prices.  However, none of the criticism to date has addressed the potentially misleading financial picture that the creditors, courts and regulators may be getting from the accountants about the financial health of the entity emerging from bankruptcy (post BK firm). The accounting culprit this time is something called “fresh-start” accounting.  For those of you unfamiliar with this reporting tool, John M. Bonora provides an excellent summary of “fresh-start” accounting in “Fresh-Start Reporting: An Opportunity for Debtor Companies Emerging from Bankruptcy.” Note the use of the word “opportunity”…

One would think that the reorganized entity would be financially sound and stable, right?  And shouldn’t the new shareholders have some prospect of earning a return on their investment?  Well, this is exactly the picture that this financial reporting “gimmick” helps a post BK firm paint.  Rather than continuing the reporting of the old bankrupt entity, fresh-start financial reporting reflects a new entity with no beginning retained earnings or deficit with asset and liability values that are reset to their fair value.  Sounds theoretically appropriate, right?  Well, as with so many things, it’s the execution that’s the problem.

Not surprisingly, Jon Weil noted this problematic accounting back in 2010 when General Motors emerged from Chapter 11 bankruptcy protection. At that time he used terms like “funky numbers” and “fluffy balance sheet” to describe the less than transparent financial reporting caused by this accounting technique. And I applaud Jon for his excellent descriptors.  So what’s the problem: our old friend goodwill.  As Jon pointed out, goodwill normally results from a buyer paying an excess purchase price in an acquisition.  But when a post BK firm adopts “fresh start” reporting, the goodwill is something quite different, causing the company to appear to be financially healthy, when it is not.

Let’s see just how new American’s “fresh-start” balance sheet might look.  First, we have to come up with an estimate of the post BK firm’s reorganization value.  Generally, reorganization value is computed using a variety of different factors including forecasts of operating results and cash flows of the new entity.  In the case of new American, this is a big problem given its continued negative operating results and cash flows.  And since the “bride and groom” in this potential union did not share their blissful forecasts with this Grumpy Old Accountant, I decided to rely on the market to create an estimate of new American’s “fresh-start” balance sheet.

I estimated the value of the merger deal to currently be about $12 billion.  This valuation is based on the recent average price of US Air common stock ($16) multiplied by the its diluted number shares reported in US Air’s most recent 10-Q, page 5 (207,439,000 shares).  This means that US Air’s investment in new American is worth $3.319 billion.  Since US Air shareholders would own only 28 percent of the new American Airlines group after the merger, reorganization value would be approximately $12 billion ($3.319 billion divided by 28 percent).  This essentially also yields total stockholders’ equity for new American.

According to “fresh-start” accounting rules (ASC 852-10-45-20): 

the reorganization value of the new entity shall be assigned to the entity’s assets and liabilities in conformity with the procedures specified by Subtopic 805-20 (Business Combinations – Identifiable Assets and Liabilities, and Any Non-controlling Interest).

In short, the accounting is similar to that applied to purchase business combinations, with reorganization value being analogous to the purchase price in an acquisition.  So think of the $12 billion as the purchase price.  This total value then is to be allocated to the identifiable assets and liabilities of the entity with any excess being allocated to goodwill.

At this point, a simplifying assumption is in order.  Given that new American is coming out of bankruptcy, where it’s balance sheet values were clearly scrutinized and adjusted, I assume that any fair value adjustments to its balance sheet will be minor, and that its June 30, 2013 asset and liability values approximate fair value.  Based on my review of US Air’s fair value note, I made the same assumption for it.  By the way, since this is likely a “tax free” reorganization, the deferred tax values are likely to remain relatively unchanged, as there will be no tax deduction for reported goodwill (i.e., a permanent difference).  So, to compute a pre “fresh-start” balance sheet for new American, I simply added the June 30, 2013 balance sheets for both companies together as illustrated below.   

 Now comes the fun part.  According to American’s 10-Q, liabilities subject to compromise totaled $5.834 billion at June 30, 2013.  Since these parties will ultimately get common equity according to the transaction terms, I backed these obligations out of debt and added them to common equity (noted by (a)).  However, to balance to the $12 billion reorganization value/shareholders’ equity number, I deducted $575 million from common equity and goodwill.  Next, I zeroed out retained earnings by adding $15.583 billion to goodwill.  The result…a $52.6 billion behemoth with over 30 percent of its assets in goodwill!

Not a problem you say?  Well then, just where did the goodwill come from? It is nothing more than capitalized prior year old American LOSSES. I would not have a problem at all with this so called “fresh-start” intangible if we renamed it “Prior Company Capitalized Losses.”  Now that would be transparent!  Probably wouldn’t be too good for future stock prices, huh?  And impairment would likely be assured…

Still not convinced.  Then consider the view of Thomas  Lawton who indicates:

beyond operational and financial synergies, this merger does not, in and of itself, fix many key competitive challenges that beset both airlines.

So just why would we expect new American’s goodwill to have any value?  An if Lawton is correct, there also is little likelihood that any new “identifiable intangibles” other than goodwill will find their way to new American’s “fresh-start” balance sheet, thus reducing goodwill.  

Many of you are probably thinking, everybody does it…so what?  And you’d be correct.  After all, Delta Airlines used “fresh-start” reporting on its emergence from bankruptcy in 2007.  But new American’s goodwill will dwarf that of Delta.  Using accounting data from Wharton Research Data Services Compustat for FYE 2012, this is how new American stacks up with other major players in the airline space when it comes to intangibles, intangibles to total assets, and tangible stockholders’ equity:

Should my estimates hold, new American’s goodwill number will swamp that of the other major carriers.  If we are to believe the analyst Hewitt Heiserman, that a ratio of intangibles to total assets over 20 percent is a cause for concern, then we should really be worried.

As if this projected goodwill amount is not high enough, there’s also the potential for this intangible to go even higher than my forecast.  Any increase in “fresh-start” liabilities might add more goodwill.  For example, old American has a significant amount of off-balance sheet arrangements that just might qualify for the “fresh-start” balance sheet (e.g., liabilities related to variable interest entities, special facility revenue bonds, general operating leases, etc.).  Also, if US Air’s stock price goes higher, then the “excess purchase price” will increase, again yielding more goodwill.

Then there is the issue of negative tangible stockholders’ equity.  After deducting the aforementioned Prior Company Capitalized Losses from “fresh-start” stockholders’ equity, new American finds itself with a negative tangible stockholders’ equity number of $4.4 billion.  This brought to mind an eloquent statement made by Tom Selling of the Accounting Onion when discussing the accounting anomaly called “negative shareholders’ equity”:

Who wants to invest in a company, especially after fresh-start accounting is applied, whose assets and liabilities are so obviously out of whack?

And I couldn’t agree more.  Despite all of the cost reductions and labor agreements and revenue enhancements noted by old American in its FYE 2012 10K (page 38), the fact of the matter is that negative tangible stockholders’ equity means the post BK firm will have more liabilities than income producing assets…clearly, “out of whack.”

Finally, there is the virtual certainty of future write-offs of the “fresh-start” goodwill.  Old American even acknowledges this possibility in its FYE 2012 10-K (page 28).  And to make matters worse, the airline industry has a recent history of goodwill write-offs.  According to a study by the Financial Executives Research Foundation conducted by Professor Mark Holtzman and William Sinnett, airlines impaired 65 percent of their goodwill during 2008.  For example, in July of 2008, both United Airlines and US Air wrote off significant amounts of goodwill, $2.2 billion and $622 million, respectively.  US Air’s charge is particularly noteworthy because it related to goodwill from its America West merger which occurred just three years earlier in 2005.  

So what’s the take-away here?  Courts, creditors, and regulators beware!  The post BK firm is likely not as healthy or viable as the accounting magic of “fresh-start” reporting would suggest.  As a final decision on this merger transaction nears, I would encourage decision-makers NOT to ignore economic reality. This industry is characterized by fierce service and price competition, fuel cost volatility, high debt levels, and a host of factors that put a premium on “real” financial strength.  Does the post BK firm have a chance?  The “fresh-start” numbers seem to say yes, but…

 
Courage is doing what you’re afraid to do. There can be no courage unless you’re scared.
— Eddie Rickenbacker

Scared yet? 


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


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During the past few weeks, we have been flooded with countless notices on the advent of a “new audit report.” According to at least one such article, an “extreme makeover” is needed to address growing investor concerns about company performance and Big Four accounting firm (BFA) audit quality.  However, any debate over a “new audit report” is a poor use of time, as the solution to accounting restatements and declining audit quality likely resides with corporate management, not the accountants.

And the recent London Whale case provides a clue as to what really may be ailing financial reporting today. The fact that portfolio losses could be hidden in a global financial services firm with the stature of J.P. Morgan Chase is astounding, particularly given the lessons that should have been learned from the Financial Crisis of 2007, and past trading scandals at UBS, Barings Bank, and the like.  

As with so many high profile “accounting failures” since the turn of the century, the major problem was NOT really with the accounting, or even the auditors.  Sure, both could have been better, but the real culprit in virtually all of these cases was the company itself!  And recent investigations appear to confirm the same result in the recent Whale Case: an internal controls failure.

So, exactly what are these things called “internal controls?”  Well, the Committee of Sponsoring Organizations (COSO) of the Treadway Commission defined internal control broadly as: 

a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance.

Still not clear?  Well, the Center for Audit Quality adds a bit more specificity suggesting that:

internal control includes all of the processes and procedures that management puts in place to help make sure that its assets are protected and that company activities are conducted in accordance with the organization’s policies and procedures.

All sounds pretty technical and boring, huh?  Well, simply put, internal controls are how management makes sure the company’s business model is operating correctly.  

Since both managers and investors need timely and accurate information, internal controls over financial reporting (ICFR) in particular have attracted a lot of attention over the past four decades, usually in response to some catastrophic audit failure or accounting collapse:

  • The Foreign Corrupt Practices Act of 1977 (“FCPA”) first required public companies to establish and maintain a system of internal control.  
  • Then, in 1985, the National Commission on Fraudulent Financial Reporting (the Treadway Commission) recommended that COSO develop a common perspective on internal control, which ultimately happened seven years later. 
  • Finally, the Sarbanes-Oxley Act of 2002 required public company management to annually assess the effectiveness of ICFR, and report the results to the public. 

However, an ICFR focus is limited in that it restricts attention primarily to accounting systems that support financial reporting. Consequently, accountants and auditors tend to view ICFR mechanically and procedurally, often ignoring internal controls outside the accounting systems.  And that’s a problem!

Lin and Wu note that accounting did not cause recent corporate scandals, management did. The misleading financial statements characteristic of most accounting and audit failures resulted from poor management decisions, often the result of weak or non-existent internal controls.  So, making accountants and auditors scapegoats for bad management, masks the real issue.

And just how bad is this internal control problem?  Well, if we focus solely on ICFR, it’s pretty discouraging.  According to Audit Analytics, management reported ineffective ICFR in almost 20 percent of registrants over the past three years.

And the internal control breaches are not isolated to any one particular area according to Chao and Foote, who researched public company deficiencies between 2004 and 2011.  

So, why might this be the case?  One major factor just might be the pressure to innovate.  In their rush to be perceived as “world class,” companies are striving to create high customer value (i.e., world class effective), through low-cost operating models (i.e., world class efficient).  Today’s business leaders routinely label business process reengineering as innovation as they seek ways to grow margins, often through aggressive cost cutting.  And frequently the target of cost reduction is middle management, where many internal controls often reside, as noted by Melissa Korn in “What’s It’s Like Being a Middle Manager Today:” 

What’s different now is that companies are leaner than ever, placing greater demands on staff even as they invest in technology that threatens to eliminate many jobs. Companies are asking managers to do more, challenging them to create and innovate while still developing talent and meeting deadlines.

And Lynn Brewer in “Fraud’s House of Cards,” warns us of the possible unintended consequences of aggressive restructuring activities:

Finally, as layoffs or reorganization may become necessary, the key to success is going to be flexibility and agility versus cutting corners, which may lead to fraud.

Next, the popularity of inorganic growth strategies (i.e., mergers and acquisitions (M&A)), particularly in the technology, healthcare, and financial sectors, also may have contributed to the breakdown in internal controls.  Given the historically high failure rates of most M&A transactions, often due to poor post-merger integration, I would not be shocked to see poor internal controls as an outcome in most of these M&A deals.  And recent federal securities class action litigation seems to confirm my concerns about M&A transactions in general, and ICFR.

Finally, there is the sad, but simple truth that far too few of today’s managers really understand what goes into creating and executing a good business model.  And key to the effective functioning of a business model’s processes are the aforementioned internal controls over systems and reporting.  Managers must not only “talk the talk,” but also “walk the walk,” when it comes to business model details.

And the current situation has the potential for even getting worse. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 exempted companies with less than $75 million in public float from having an auditor report on ICFR.  And last year’s Jumpstart Our Business Startups (JOBS) Act legislation also provided disincentives to build solid internal controls.  According to Chris Dieterich in a recent Wall Street Journal article:

Nearly three-quarters of the 87 U.S. companies that publicly filed their IPO registration between the start of April and year- end counted themselves as “emerging-growth,” the data showed…Every emerging-growth company that filed IPO documents last year used JOBS Act provisions to opt out of outside audits of their internal controls for longer than previously allowed…

Proponents of “emerging-growth” company (EG) internal control reporting exemptions claim cost savings that promote business development.  The reality is that most EGs simply have no internal controls.  

In fact, this Grumpy Old Accountant recalls participating as a staff auditor in a tech company IPO several decades ago.  This client’s claim to fame was the development of a “super slow-motion” camera lens that eliminated blur from still pictures taken at sporting events.  The hope was that the engineer-owners of the firm would enrich themselves with the rapidly approaching summer Olympics.  However, a major IPO hurdle was that the company had no books and records!  The owners literally brought grocery bags filled with receipts and cancelled checks into our then Big Eight firm office conference room.  From those documents we then constructed and “audited” a set of financial statements for the IPO registration statement.  Do we really believe it is all that much different today?  I seriously doubt it…

Interestingly enough, a recent governmental report linking exemption from ICFR attestation with accounting errors has not received much press. The U.S. Governmental Accounting Office (GAO) found that the number of accounting errors (i.e., restatements) was higher for companies exempt from auditor attestation of ICFR than for nonexempt companies from 2005 to 2011.  As a result, the GAO recommended that the U.S. Securities and Exchange Commission (SEC) require all public companies to disclose whether they obtained an auditor attestation of their ICFR to increase transparency for investors.  Is this really too much to ask of companies seeking access to our capital markets?  

But there does remains one thorny issue…who can we trust to report on a company’s internal controls? Apparently the BFA are not only poor financial statement auditors, but according to the Public Company Accounting Oversight Board (PCAOB), they also aren’t very good at evaluating internal controls, even after presumably all of the “experience” they gained doing Sarbanes-Oxley 404 work. Or should that work be suspect as well?  Should we really be surprised that technical GAAP specialists don’t know a thing about business processes?

So where does all of this leave us?  As Albert Einstein said, “ In the middle of difficulty lies opportunity.” Here are a couple of thoughts:

  • Given the recent shift to principles-based accounting (i.e., reliance on management judgment), continued decline in BFA audit quality, and the ever-widening “expectations gap,” it may be time to de-emphasize reliance on “audited” financial statements.
  • Instead, require ALL publicly traded companies to have a periodic, independent third-party evaluation of their internal control systems, including ICFR.  This evaluation would be performed by a non-BFA firms selected by the SEC on a rotational basis, and paid for by the publicly-traded company being examined.  Companies could actually lower their review costs by having high quality control systems that might actually contribute to strategy execution.
  • The PCAOB could shift the majority of its oversight duties away from evaluating financial statement audits to monitoring internal control evaluations.

This internal controls focus just might end the fruitless debates about auditor rotation, partner signatures, and the like.  It also could grow the market for “audits” of internal control systems, and encourage the development of new internal control specialist firms other than the BFA, thus diminishing the current “too few, to fail” concerns of the regulators.

With all of the accounting and auditing problems bombarding us today, we should focus on the common denominator: most accounting errors and audit failures have their roots in the failure of a company’s internal controls.  Consequently, management should be held responsible for this crisis in investor confidence, not the accountants.  And it sure seems like internal controls are central to earning this confidence.  If not, we are left with the old idiom: garbage in, garbage out!

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AuthorAnthony Catanach

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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