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  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!

AuthorAnthony Catanach

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!

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.

AuthorAnthony Catanach
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Can ethics be taught?  As an accountant, and an aging one at that, I am not qualified to answer this question.  But Socrates debated this very question with his fellow Athenians almost 2,500 years ago.  And his conclusion then apparently was that it could be.  But then again, Socrates had not met Sam E. Antar.  

This past week I spent several very entertaining and interesting days with Sam E. Antar who profoundly affected the way I view white-collar fraud, and the ability of auditors to detect it.  Did he “con” me?  Was I another one of his unwitting victims?  Perhaps, but I now realize that accounting and auditing professionals are particularly at risk to “crooks” like Sam.  But before I share my observations with you, a bit of background is in order.

Business ethics training is clearly a big deal today, its increased importance largely the result of recent high profile corporate failures, and regulatory attempts to prevent their reoccurrence.  Just look around you.  Most business schools now have required ethics courses for both undergraduate and graduate students.  Ethics education requirements also are now the norm for the licensing and certification of both financial and management accountants.  In fact, these new ethics training rules have prompted many professional associations to create a “new ethics training industry” to meet the continuing professional education (CPE) needs of their members.  

But does any of this work?  Despite their having taken semester-long ethics classes, I still catch students cheating on exams and course assignments.  What does this tell us?  And then there are the numerous ads for “free” or “cheap” on-line training courses.  This Grumpy Old Accountant is beginning to wonder whether the professional organizations that promote these CPE programs have actually taken their own courses.  Just how much ethics can one learn in an on-line course in a couple of hours?  After all, don’t you get what you pay for?  And some of you will no doubt remember the Grumpies’ rants about how “the large accounting firms have effectively demagnetized the profession’s moral compass,” in “Accountants Behaving Badly.

So what’s the problem?  Philosophy professor Joseph R. DesJardins defines it clearly when he acknowledges that teaching ethics is simply a “difficult task.”  And  I agree with him completely, while believing that training offers only a partial solution to the increasingly complex ethical dilemmas we face in accounting today.  Cultural reforms and enforcement cannot be ignored either.  There is just no quick fix…and apparently Crazy Eddie’s former auditor doesn’t believe any remediation is in order to address their “rogue” auditor’s recent behavior.  But I digress…

So, where does Crazy Eddie come in you ask?  This past week I decided that “desperate times call for drastic measures,” particularly when it comes to trying to convince my graduate accounting students that ethical and transparent financial reporting and effective auditing are important.  Who better than a convicted felon and mastermind of one of the largest securities frauds in US history to “lecture” my students on white-collar fraud. Yes, Sam E. Antar, former chief financial officer of Crazy Eddie, who has admitted to such inappropriate behaviors as skimming, money laundering, and insurance and securities fraud.

Now let’s be clear…Sam has made numerous speaking appearances to a wide variety of organizations and students, and consults regularly with governmental agencies on white-collar fraud.  So, apparently this is how Sam “makes a living” these days (at least we can only hope).  But spend a couple of days with this former criminal, and you’ll find out that he is not just another consultant spewing out the purported benefits of the Cressey “fraud triangle.”  What makes this man unique (and dangerous) is his complete lack of remorse for his past crimes.  In his own words:

Apologies for my crimes are irrelevant. Apologies do not undo the losses suffered by the victims of my crimes. I do not seek or want forgiveness for my crimes from my victims.
— Sam E. Antar

And it is ironic that this lack of remorse is viewed by some accounting professors as deplorable, making him unfit for the classroom.  Perhaps that’s why he has never spoken to the American Accounting Association, the professional organization for accounting academics.  On the contrary, this is exactly the type of person our accounting faculty and students need to meet and question: a predator, a charmer, a scammer.

Yes, it was fascinating to relive the Crazy Eddie accounting frauds (and they were numerous), particularly since I was a KPMG auditor (Crazy Eddies’ firm) during the public company phase of the Antar family’s scam.  It was interesting to see how the Antar “crime family” adapted its business model to strategy changes from skimming as a private company, to inflating profits as a public company, all in pursuit of the “game.”

Imagine just how corrupt the family was, that it even sent young cousin Sam to business school to learn accounting for the public offering phase of the Crazy Eddie fraud.  Oh, and by the way, Sam was an honor student in accounting, and passed all of the CPA exam in his first attempt.  Here are a couple of questions for you…if Sam had taken an ethics course in college, what grade do you think he would have earned?  Do you think the class would have redirected him from a life of crime?  The answers to both queries are pretty obvious, right?

Nevertheless, here are some of the very troubling insights that I took away from my two-day “retreat” with Sam.  First, and probably the most disturbing, is that 10 percent of the public is absolutely unethical and incapable of behavioral change.  In making this claim, Sam cited a study by Crowe Horwath, and pointed out that Cressey’s “fraud triangle” does not account for such individuals, since they do not (or even need) to explain or justify their behavior.  This “evil” 10 percent simply like what they do, and don’t need to rationalize. As Gordon Gekko noted in the movie Wall Street: “It’s not about the money…it’s about the game.”

What are the implications of Sam’s sobering assertions?  If he’s right, ethics education may be pointless for this “criminal” element of our society.  Equally troubling is that this 10 percent is quite likely to be attracted to the capital markets (as was Gordon Gekko), like a “moth to a flame.”  This means that accountants and auditors will undoubtedly encounter these individuals at some point during their careers.  This Grumpy Old Accountant worries that today’s accountants and auditors simply won’t recognize the “devil” when they meet him or her.  Why you ask?

My second big takeaway from Sam was how white-collar criminals operate.  Exploitation and façade accurately describe the way they function.  According to Sam, this evil 10 percent exploits your humanity.  They take advantage of your ethics, morality, and good intentions.  The more ethical and moral you are, the easier it is for the scam artist to con you because you simply can’t believe that people act inappropriately, or contrary to your own personal moral code.  In short, you are “ripe” for exploitation.  

What does this mean for our young, impressionable, idealistic accountants entering the profession?  They are like “lambs to the slaughter.”  They generally come from good schools, moral families, and most have been raised to believe in the good in people. They are clearly incapable of dealing with the likes of Sam Antar, particularly when he employs two other tools of the white-collar criminal: flattery and distraction. 

Complementing a person’s appearance or intelligence lowers the victim’s defenses. Will auditors (both junior and senior) recognize that this is happening? And distractions can be particularly effective in reducing audit quality.  Sam reports that as CFO one of his goals was to get his auditors off schedule by pushing 80 percent of their audit work into the last 20 percent of their scheduled audit time.  The result: either more errors in the test work performed or procedures would be scrapped altogether for the sake of completing the audit as scheduled. Do our auditors today consciously think about such things?

As a side note, Sam suggests that accountants with “street smarts” probably would make better auditors.  Given their “inner city” backgrounds they have been raised around the criminal element, are less trusting, and are more likely to recognize when they are being scammed.  This observation may just highlight another crack in the large accounting firms’ audit models, given that they hire almost exclusively from the top business schools, where “street smarts” is neither on the admission criteria or in the curricula.

Finally, there is the white-collar criminals use of façade.  These evil-doers routinely cloak themselves with an aura of “false” integrity to gain the trust of their victims.  For example, they may be well respected “pillars of the community” known for their charitable contributions, or even recognized by industry professionals for their accomplishments.  The façade makes it less likely that someone will question their actions and behaviors.  When it comes to auditing, how likely is it that today’s large accounting firm auditors will challenge their famous big-shot clients?  Do we really expect them to “bite the hand that feeds them?” So, what is Sam Antar selling today?  Is he all about improving ethics in today’s society?  Is his goal to improve auditing and fraud detection?  Or is this all some clever new façade to gain our trust?  I don’t know, and frankly, I don’t care!

All I do know is that two days with Sam Antar left me with more questions than answers.  This convicted felon is causing this Grumpy Old Accountant to reevaluate his positions on a number of issues:

  • What is the “best” way to prepare our accounting students for dealing with the ever increasing moral lapses found in business today?
  • Can regulatory intervention like Sarbanes Oxley really make a difference when it comes to the evil 10 percent?
  • Should auditors be focusing more on detective controls and substantive testing than preventive controls?
  • How can large accounting firms effectively promote auditor skepticism when they simultaneously differentiate themselves as “valued business advisors” to their audit clients?

In short, are today’s accountants and auditors really ready to deal with white-collar criminals?  Again, did Sam Antar “con” me?  Perhaps, but at least I now recognize the possibility.


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

AuthorAnthony Catanach
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Those who extol the virtues of U.S. capital markets are quick to tout their transparency. In this case, it is sadly and needlessly lacking.
— David Reilly, Heard on the Street, Wall Street Journal, April 9, 2013

In making this statement, Mr. Reilly was referring to the paucity of information which investors and markets have regarding the accounting firm partners responsible for auditing today’s large global companies.  In “Looking for KPMG’s Mystery Man” he discusses several benefits of disclosing the name of the engagement partner which may improve audit quality.  But while knowing who the responsible partner is would be interesting, many would agree that this information alone probably wouldn’t have prevented KPMG’s recent independence fiasco.  This grumpy old accountant would like much, much more information about the large accounting firms who are supposed to be the “gatekeepers” of the public securities markets.

After half a century of blown audits (that’s as far back as this old bean counter can remember), these firms and their partners have somehow garnered “too few to fail status,” and continue to disappoint us.  And as Michael Rapoport reports, these firms have given us such accounting highlights as the financial crisis of 2007, and just last year, a Deloitte partner’s insider trading.  And now we have a 29-year, life-long KPMG audit veteran, with responsibilities for more than 50 other audit partners and over 500 employees, caught accepting envelops of cash for passing along privileged information.  And David Reilly’s call for more transparency (opening quote), prompts one major question…what do we really know about these firms who are supposed to be protecting the investing public?

Who are the Big Four and how did they become so powerful?  It’s been almost 30 years since Mark Stevens gave us a glimpse of these firms in The Big Eight and The Accounting Wars, so we really don’t know what they look like on the inside today.  And because of their operating structure, they are not required to disclose any of the information that we have been accustomed to in the 10-K annual reports filed by publicly traded firms.  We have no idea what their strategies are, the full extent of the risks to these strategies, or what their business models are.  Most importantly, we are clueless as to their financial condition and who their senior leaders are, or even what the governance structure looks like, much less its effectiveness.  Given the increasingly routine subpar performance of these large accounting firms, why do the regulators continue to let these firms get away with selling a clearly defective product.  What’s going on here?  Shouldn’t we know more about our “gatekeepers,” particularly since they appear to have left the gate wide open?

I am also somewhat troubled by the market’s recent reaction to KPMG’s recent partner scandal.  This is much, much more than simply another insider trading story.  I agree with James D. Cox, who called the case a “Bombshell that has the industry circling the wagons on training.”

There is simply no getting around it…this is a watershed event…this is a once in a generation occurrence…this is much worse than Deloitte’s insider trading problem.  Why?  This is about a major accounting firm violating the bedrock independence standards upon which the auditing profession is founded.  Mind you…this is not just another accounting restatement (although those are problematic as well).  So serious is the situation that KPMG actually withdrew its audit reports on multiple client financial statements for several years.  

The current KPMG debacle also highlights the failure of legislators and regulators to adequately address the independence issue last decade.  Although Section 201 of the Sarbanes-Oxley Act of 2002 created significant independence rules for non-audit (consulting) activities, they did little to beef up the actual policing of independence at accounting firms.  The limitations on consulting activities were largely a band-aid to address blatant independence violations during the Enron era.  Current professional standards largely require accounting firms to implement policies and procedures to provide reasonable assurance that personnel maintain independence.  And these can be quite “stringent” for KPMG and other accounting firms.  So, what’s the problem here?  The independence control procedures are largely self-reporting in nature.  That means that self-disclosure of independence violations is fundamental to most of the firm internal controls.  So, is it any wonder that KPMG was blindsided by its partner’s behavior. It appears that the firm actually was notified by federal investigators of the “rogue” behavior!  Shouldn’t the firm be ashamed that its own internal controls don’t work?  And we haven’t even discussed possible “failure to supervise” issues at KPMG, a topic that the Public Company Accounting Oversight Board will surely examine.

Given that independence, self-reporting, and firm culture all seem to be somewhat related, does this “rogue” KPMG partner’s behavior tell us anything about the firm’s culture?  Or about our society in general?  Here are a couple of examples from the recent press related to this 29-year veteran that concern me greatly:

This KPMG partner regrets his actions (now that he has been caught) after engaging in behavior that was “wrong” for a period of several years.  In fact, in his own words he felt guilty about it regularly, can’t explain it, and attributes it to “humans make mistakes.”

This KPMG partner tells us that he divulged “no real significant information,” and that his “take” was a watch discount, a couple of dinners, and a couple of thousand dollars in cash.  But instead we find out that he provided advance notices of earnings releases and merger plans, and in exchange “reaped more than $50,000 in cash and gifts, including a $12000 Rolex watch.”

Clearly, the “rogue” is trying to minimize his jail time, but I have yet another question.  Why does a senior, 29-year partner, with significant supervisory authority in one of KPMG’s largest offices behave this way?  Surely he didn’t need the money…the “why” is really nagging at me, and prompts me to question the firm’s culture. Shouldn’t we be concerned that this partner might actually reflect the system into which he was hired, trained, and promoted over almost 30 years?  Also, what about the effectiveness of ethics training at this firm and others, particularly at the senior level…and again what about leadership?

KPMG’s current catastrophe and PricewaterhouseCoopers’ recent quality control issues (which I discussed in “Is FASB Killing the Auditing Profession?”) reminded me of Marianne Jennings’ book titled “The Seven Signs of Ethical Collapse.”  As I reread Chapter One, I began wondering how many of the seven warning signs could apply to  the big accounting and auditing firms.  Three signals particularly jumped out at me:

Pressure to maintain those numbers – Given their size, one can only imagine what Big Four performance pressures might be.  After all they continue to protest regulatory attempts to improve audit quality, citing costs and pricing as issues.

Weak board – We have virtually little or no information on the governance of the large accounting firms.  But given their track record in protecting the public for the last half century, can’t we conclude that  there are some problems in this area?

Goodness in some areas atoning for evil in others – The big accounting firms deluge us (at least the academic community that is) with tales of their outstanding community and public service.  Could these actions be attempts to somehow make up for their “gatekeeper” failures?

In short, is there a festering cultural problem at these firms that makes them increasingly incapable of doing their duty to society?  After all, it was supposedly another “rogue” that took down Arthur Andersen in Houston, right?  I’m sorry…the “rogue” excuse is beginning to wear thin after all of the accounting and trading scandals we have witnessed recently.

Jennings in Chapter Ten also suggests that transparency may offer a solution to this “ethical collapse” issue.  She proposes clarity, honesty, and full disclosure.  Why can’t the large accounting and auditing firms “practice what they preach,” of their clients. Tell us more about who you are, what you do, and how you do it?  Admit your mistakes and tell us how you are going to fix it.  And then follow through and actually correct it!

Unfortunately, the spin to minimize legal exposure at KPMG has already begun. When this saga ends, we likely will conclude that we have seen this picture before.  A tale of weak and ineffective controls, missed signals, and greed…sound familiar?  Then, there is the standard “mea culpa” and promise to do better in the future. Shouldn’t the standard be higher for a firm of professionals?  One would think so…

And let’s not forget all the others that will use this case to promote their own policy initiatives.  Let’s try not to be blinded by the quick fix “solutions” (e.g., naming engagement auditors, audit rotation, etc.).  For example, while naming the auditors on an engagement sounds like a good idea, it might actually make things worse!  I would propose that good auditors (many of whom by nature are risk averse) might actually flee the large accounting firms if their names are disclosed, unwilling to put their limited wealth at risk for making an “honest” mistake in today’s litigious society.  This would leave the “rogue” risk takers to fill the engagement partner roles.  Just a thought…

The fundamental issues are, and have always been, independence and transparency.  Until we the investing public actually somehow become a contractual party to the audit with auditor hiring and firing authority (and I don’t mean via the board of directors), we are wasting our time.  We also need to know much, much more about the large accounting firms to better understand why their behaviors will likely never change in our lifetime (if ever).  Pretty grumpy, huh?

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

AuthorAnthony Catanach

Well, the auditing profession appears to have finally hit the “bottom of the barrel.”  The demise of the respected Arthur Andersen firm in the wake of the Enron scandal was a huge disappointment.  And now PricewaterhouseCoopers (PwC) has failed us by not living up to the high standards set by its legacy firm.  For those of you too young to remember, Price Waterhouse & Co. was the Brooks Brothers of the accounting and auditing profession at one time.  As Mark Stevens in The Big Eight noted in 1981 (yes, over 30 years ago), Price worked hard “to retain its image as the gilt-edge CPA firm.”  My how times have changed!

So what happened?  On March 7, 2013, the Public Company Accounting Oversight Board (PCAOB ) reported that the PwC had failed to address certain audit related quality control criticisms levied at the firm in previous PCAOB inspection reports, not once but twice, first in March 25, 2009 and then again in August 12, 2010.  What makes this so interesting is that the issues raised in those previously issued reports would have remained “private” had PwC simply corrected the problems within 12 months of the reports’ issuance.  While this is not the first time that one of the Big Four has thumbed their noses at the PCAOB (Deloitte felt the PCAOB’s wrath in October 2011), it is surprising that “a leader in the profession” (and yes, those are PwC’s own words) has done so. You may recall that the Grumpies were not wild about this behavior the first time it happened.

Well, Lynn Turner, a former Chief Accountant of the U.S. Securities and Exchange Commission (SEC), in a recent email (March 7th) to his distribution list, has asked the million dollar question:

What kind of leaders are running the firms, what type of governance do they have, that provides that type of response to the regulator?

Just look at PwC’s response to the PCAOB in its March 7, 2013, Release No. 104-2013-054:

The Part II comments relate to some of the most complex, judgmental and evolving areas of auditing. Our actions relating to those areas, during the 12 months following issuance of the  comments and thereafter, have included providing our audit professionals with enhanced audit tools, training and additional technical guidance to promote more consistent audit execution. We believe that these efforts have been important positive contributors to audit quality at our firm. We are proud of our focus on continuous improvement and of the dedication and high quality audit work performed by our partners and other professionals.

Wow!  This hints at an admission by PwC that its highly paid auditors were not properly trained to audit publicly traded firms.  If this is indeed the case, we surely can’t overlook the ethical implications of a firm contracting to do work for which it was not qualified. This never would have happened at Price Waterhouse & Co. What really bothers this grumpy old accountant is that PwC just doesn’t get it. The old “we’ll try harder” language is just not acceptable.

Just look at a couple of the more glaring audit quality control problems plaguing PwC.  First, there is the supervision issue.  Apparently, some PwC engagement partners are spending miniscule amounts of time on their engagements (see PCAOB Release No. 104-2009-038A  page 23).  Remember, these are the same engagements that PwC (in responding to the PCAOB) indicated involved “some of the most complex, judgmental and evolving areas of auditing.”  How could PwC allow this to happen?

Particularly troubling is PwC’s “let them eat cake” attitude in addressing PCAOB concerns such as “failure to adequately challenge management assumptions, excessive reliance on management's responses to inquiries, and the failure to respond appropriately to potential issues identified during the audit.”  Apparently, PwC engagement teams view cumulative audit knowledge and experience (CAKE, a PwC acronym) as a “source of substantive assurance” in their audit model, which may have undervalued skepticism, supervision, and good old fashioned audit procedures (see PCAOB Release No. 104-2009-038A page 14).

And while I am on the topics, skepticism and supervision are NOT just about technical competency and/or having someone review your work.  Skepticism and supervision require competency, experience, judgment, and strength of character, traits typically found only in seasoned, grumpy old auditors…like engagement partners.  So, is it really surprising that the PCAOB found problems in these areas given the firm’s reduction in partner engagement time?

Also, let’s be clear on what the PCAOB really means by “quality control system.” This is the audit model itself…the activities and procedures used by an accounting and auditing firm to actually execute an audit.  So, when the PCAOB finds problems with how PwC audits estimates, fair value, and revenue recognition; evaluates controls; and uses specialists, it raises serious questions about how the firm’s business processes function. So, what PwC and its three other Big Four cronies really need is a new “audit model.” 

As you may recall, a financial statement audit opinion is supposed to certify that a company’s reports comply with generally accepted accounting principles (GAAP).  Complicating matters is the fact that GAAP has become so “complex” and “judgmental” (and those are PwC’s own words) that the current audit model (essentially unchanged for 75 years) may no longer be useful.  Evidence that today’s GAAP is wreaking havoc among auditors can be found in another PCAOB report (Release No. 2013-001) dated February 25, 2013 which summarizes results for inspections conducted in 2007-2010 of 578 audit firms involving 1801 audits.  Just look at some of the problem audit areas identified by the PCAOB…these again are all significantly judgment focused: revenue recognition, fair value measurement, business combinations and related intangibles, and estimates.  So, as the Financial Accounting Standards Board (FASB) makes it headlong rush into fair value reporting and abandons two key qualitative characteristics of financial reporting, faithful representation and verifiability (discussed in Concept Statement No. 8), it just may be a major contributor to poor quality auditing by promulgating accounting rules that are filled with measurement error and impossible to verify.  Yes, FASB may be killing the auditing profession!
Some of the FASB’s finest work surfaces at the heart of the auditors’ problems: software transactions, multiple-deliverables, gross vs. net. (see PCAOB Release No. 2013-001 pages 11 and 12).  Yes, the some of the very same issues that the grumpies have been harping about for several years. The complexity of such transactions begs for accounting experience, and it is sheer lunacy to expect junior auditors (those with less than five years of diverse experience) to deal with these transactions.  
Then there is fair value accounting, the centerpiece of the FASB’s standard-setting for the past decade.  When it comes to assessing controls and substantively auditing assumptions and valuation models (see PCAOB Release No. 2013-001 page 17), today’s auditors seem to fail miserably at both junior and senior levels.  Again, we must ask why?  Despite all of the firms’ assertions, audit staffs simply haven’t been trained adequately in the accounting and auditing of these transactions.  Heck, in most cases, the clients don’t understand them either.  And who gave us the accounting that motivated (or in some cases encouraged) these transactions…the FASB!
Then there is the FASB’s stubborn commitment to goodwill and asset impairment testing.  If management doesn’t know why it paid an excess purchase price for an acquisition, can you really expect an auditor to ascertain the veracity of recorded goodwill amounts?  Why does FASB continues to play this goodwill game?  Could it be that mandating goodwill write-offs at the date of an acquisition might stifle M&A activity, since manager overpayments would be exposed to investors?  But does this really matter since research shows that most acquisitions fail to achieve their strategic goals thus rendering recorded goodwill meaningless?  Bottom line…how do you expect inadequately supervised (and often junior) auditors to audit client assumptions and estimates for assets that have no tangible existence?  The auditor has been set up to fail…by FASB!
Next, there is the issue of analytical procedures (see PCAOB Release No. 2013-001 page 32).  In the old days (when I was a junior auditor), analytical procedures resided in the domain of experienced auditors (i.e., audit seniors and above). Today, junior accountants many of whom are not even trained in fundamental financial statement analysis are commonly tasked with evaluating management explanations.  The situation is so pathetic in fact that all too often juniors fill their analytical working papers with such trite phrases as “appears reasonable, pass further work,” when additional work is in fact needed.
Then, there is the inability of today’s auditors to assess fraud risk (see PCAOB Release No. 2013-001 page 35).  With so little audit work being done by seasoned, experienced auditors, this deficiency is not unexpected.  Junior auditors would not recognize a fraud today if it jumped up and smacked them in the face.  Even in my old audit days, we laughed about giving junior auditors that old task “review the general ledger for significant/unusual transactions.”  Without experience and business sense, the young auditor will always fail in this task.
But am I suggesting that the Big Four may NOT be THE problem?  Of course not, they represent themselves as being competent to audit, so they must suffer the consequences if they don’t comply with PCAOB standards. Moreover, the Big Four are simply “reaping what they have sown.” PwC et al. may actually be getting what they deserve, since they lobbied mightily for many of the judgmental GAAP standards we now have (including the adoption of international financial reporting standards).  And why did the large accounting and auditing firms promote such accounting rules?  While they will never admit it, in part to reduce their legal liability for bad audits…after all it’s harder to be sued (and lose) when auditing a client’s estimates or judgments.  Unfortunately for them, however, the PCAOB has unmasked their shoddy auditing of judgment related accounting areas. The big accounting firms simply can’t audit the “new accounting” because they use an outdated audit model driven by antiquated staffing mixes which ignore the importance of experience and wisdom. And if inadequate partner supervision time is not a big enough problem for these firms, their relatively young mandatory retirement ages rob them of the talent they most need to audit subjective accounting issues…the senior folks who actually have experience, insights, and judgment.
So, what’s the solution?  First, dump the current cast of FASB (and IASB) characters and replace them with some practicing grumpy old accountants (that excludes Ed and me of course) who take the qualitative characteristics of useful financial information (Chapter 3, FASB Concept Statement No. 8) seriously, and who will restore such concepts as faithful representation and verifiability to the standard setting process.  The notion of relying on and/or auditing management estimates and assumptions given today’s increasingly subjective accounting is simply ludicrous.

Second, the PCAOB must move the auditing profession away from its historical audit pyramid where relatively inexperienced and inadequately trained “grunts” labor long hours to make their audit partners wealthy.  That may have worked when business transactions were much simpler, local, and slower paced.  But with today’s transaction complexity, speed, and globalization, what we need to have for quality audits is senior manager and partner time…not rookie time.  The tired, old, audit pyramid needs to be scrapped and should have gone the way of rolodexes, printed encyclopedias, phone books, film, bank deposit slips, and answering machines…AWAY.

Finally, the auditing profession must stop forcing their elder statesmen (those over 60) into retirement.  By forcing these early departures, these firms are throwing away one of (if not THE) most valuable assets that they have….experience.

So, while it brings tears to this grumpy old accountant’s eyes to see the demise of what I remember as such a great firm, PwC and the other large accounting firms are getting exactly what they deserve for promoting bad accounting standards: impossible to audit balance sheets!

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

AuthorAnthony Catanach

"It’s déjà vu all over again."  - Yogi Berra

Well, it’s been a week since the U.S. Securities and Exchange Commission (SEC) announced that it was charging a KPMG partner and senior manager with failing to properly audit a bank’s allowance for loan losses.  I share Jon Weil’s frustration with the SEC’s failure to pursue the large accounting firms for their shoddy audit work during the recent global financial crisis.  Why you ask?  It just so happens that back in the day, I actually audited financial institutions for KPMG’s predecessor firm, Peat Marwick, during the S&L crisis.  I remember well how regulators and markets “punished” big accounting firms who failed to exercise professional skepticism in their reviews of land development and construction loans, equity participations, and yes, even reverse repurchase agreements.  Despite all the angst that the S&L litigation created among auditors, it actually did make auditors think more about what they were doing.  In short, litigation losses are one way to make sure that auditors have “skin in the game.”  But I digress…

So what’s my beef this time?  Well, I am not going to pile on after Jon Weil’s and Tom Selling’s pointed comments concerning the lack of auditor enforcement actions.  After all you know how the grumpies feel about enforcement.  See PCAOB is Too Soft on Auditors, Accountants Behaving Badly, and The Auditor’s Expectation Gap for a trip down memory lane.

Instead, I am just going to reminisce (and vent) about the “golden days of auditing” (when I practiced) to highlight what I consider to be the folly of the Financial Accounting Standard Board’s (FASB) recent exposure draft (ED) on Financial Instruments – Credit Losses.  In fact, the very existence of this FASB proposal may help explain why KPMG couldn’t audit the loss allowance of TierOne Bank.

Immediately after reading page 2 of the exposure draft, I began to feel uneasy.  The FASB tells us that the proposed amendments would require:  

  • An entity to impair its existing financial assets on the basis of the current estimate of contractual cash flows not expected to be collected on financial assets held at the reporting date. 
  • That the impairment would be reflected as an allowance for expected credit losses. 
  • The estimate of expected credit losses would be based on relevant information about past events, historical loss experiences, current conditions, etc.

So what’s so unreasonable about these proposals…absolutely nothing.  This is what we were supposed to do 30 years ago!  From intermediate accounting, through bank level I and II firm training, we learned that the allowance for credit losses (whether they be for accounts receivable or loans) should be based on exactly such criteria.  So when did generally accepted accounting principles (GAAP) abandon this “old” approach, and what has been used since?

Well, page 3 of the FASB ED provides some clues.  It indicates that current GAAP delays the recording of credit losses until they are “probable.” So, apparently corporate accountants and their auditors have adopted a strict interpretation of ASC 450 which requires that a loss contingency (a loss reserve) be accrued only if asset impairment is probable and estimable. Also troubling is that entities currently can limit the information they use to measure an incurred loss to “past events and current conditions,” ignoring a wealth of quantitative and qualitative factors specific to borrowers.  

Apparently, today’s accountants believe that FASB’s pronouncements are the only thing that constitutes GAAP, choosing to ignore such tried and tested estimation techniques such as aging of accounts and percentage-of-sales methods.  By the way, both tools are acceptable under GAAP, but neither apparently meets ASC 450’s level of “sophistication.”  Back in the day, we acquired all the relevant information that we could to address the uncertainties associated with a loan receivable’s ultimate collectability.

With today’s high standard for recording a loan loss, it’s no wonder that loss allowances are being under accrued, particularly given bank management’s incentives to prop up capital levels at all costs.   So, at some point, today’s accountants opted for a strict adherence to ASC 450’s criteria when creating and auditing loss reserves, ignoring other relevant GAAP, and abandoning common sense and skepticism, as well. And the result?  A new FASB ED on credit losses (with implementation guidance) that simply confirms what we old auditors have known for decades.  Wow, how did accounting for credit losses get so far off track? 

A “war story” from my loan review days will hopefully illustrate why I am upset.  One of my all time favorite loans was a $500,000 commercial real estate credit on a car wash in a small town. The loan was over 9 months delinquent, the bank had no recent communication with the borrower, but there was a stale property appraisal from when the loan was originally approved.  The prior year bank examiner report had classified the loan as substandard, and the bank’s credit analysis department had currently evaluated the loan as doubtful.

Our concern back in those days was whether the reported loan amount (i.e., the contractual cash flows) was impaired.  Given the information provided to us, it became apparent that we had to determine and evaluate the source of repayment. I gathered up my audit team at lunch and suggested we swing by the car wash for fun to check out the loan’s collateral.  Yes, we actually conducted a visual inspection of the collateral…what a novel idea!  And what did we find?  A roofless, abandoned aluminum shell, totally stripped of machinery, laying dormant in a weed infested lot.  Yes, this was an easy one…a complete loss with a 100 percent required reserve, not even any value for the land due to environmental hazard issues. Note the similarities of this situation with that summarized in the SEC’s action against the KPMG auditors at TierOne Bank: reliance on stale appraisals and management’s uncorroborated representations.

By the way, further investigation back at the bank revealed that the aging schedule for the car wash loan had been falsified, and that relevant borrower correspondence had been removed from the loan file. Yes, my little lunchtime adventure had uncovered a bit of a fraud! You can be assured that such little trips became standard for troubled loans in my future audit engagements.  So what’s the moral of this story? You can’t audit from your cubicle…you can’t rely solely on management assertions…you can’t cut corners!  And again, this grumpy old former Peat Marwick trained bank auditor was using FASB’s newly (and recently) proposed rules, over 30 years ago. I must confess that ASC 450 (SFAS No. 5, Accounting for Contingencies) never even entered my mind during the loan review process, nor did such terms as “probable” and “estimable.”  

So what really went wrong with the KPMG audit at TierOne Bank?  If we discount auditor fraud and gross negligence entirely, potential causes fall into one of two categories neither of which is likely to lead to a “conviction.”  First, there is education…the “I didn’t know what I was doing” defense.  This might work for a newly hired auditor on up to senior, but not for a manager or partner.  They clearly had the education, specialized industry training, and years of experience necessary to plan, organize, and conduct substantive and control focused audit testing.  Unless, of course, both the partner and manager argue that they were unsure how to apply current GAAP as it relates to credit losses.

The other, and more likely, explanation for blowing the audit of the loss allowance is poor process execution.  Something undoubtedly happened during the engagement that resulted in a process breakdown.  The usual suspects are time and client fee pressures which result in judgment, organization, planning, review, staffing and/or supervision failures during the audit process.  I’d bet on this given all of the audit model failures recently witnessed, and the PCAOB’s continuing exception reports.

Oh, and don’t look to new accounting and auditing standards to fix the problem with loan loss reserves.  I agree completely with Tom Selling’s recent statement that: 

"The facts are that holding management ultimately accountable for the accuracy of financial statements doesn't work anymore (if it ever did). Different auditing standards won't make the audit more reliable as a deterrent to financial manipulation, so long as management has the license to do the estimating – and to hire and fire the auditors."

So what do I hope you take away from my ramblings about yesteryear?  First, there’s nothing really new about FASB’s Financial Instrument – Credit Losses exposure draft. I support it! However, we all should be very concerned that FASB thinks that considering contractual cash flows and all relevant information in credit loss estimation and recognition is something new!  Apparently, the FASB has no historical perspective or institutional memory…very sad, indeed.  After all, even Jerry Maguire got it back in 1996 when he screamed "show me the money!" It was true then, it’s true today, and will be for the foreseeable future when it comes to valuing assets.  And the FASB staff really ought to check out the wealth of published regulatory guidance if they want to craft a credible credit loss standard (e.g., OTS Asset Quality, Section 260 for one).

Lastly, in this grumpy old accountant’s opinion, quality accounting and auditing is less about financial measurement models and internal controls, which are valueless without the individual accountant’s commitment to common sense, sound judgment, and professionalism.  Think of me the next time you take a drive at lunch to check out that non-performing strip center commercial real estate loan…yes, the one with the nail salon anchor tenant…

This essay reflects the opinion solely of the author.

AuthorAnthony Catanach
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Honesty is the first chapter in the book of wisdom.

                                             - Thomas Jefferson

Well, it’s a New Year!  Ed’s and my letter to Santa last year was ignored again this year, so I’m taking another angle and bypassing Mr. Claus entirely.  In the hopes of restoring the glory of my beloved accounting profession, I am proposing some New Year’s resolutions for the “major players” and “heavy hitters” in accounting.

The Securities and Exchange Commission (SEC)

Those of you who have been following the Grumpies know how we feel about IFRS…no we are not wild about them.  However, the SEC did do a great job on its Final Staff Report summarizing its work plan for global accounting standards.  However, it apparently missed one big point.  Increasingly, accounting research from across the pond shows that that IFRS has failed to deliver on its promise for one set of accounting standards. Several recent studies (Kvaal and Nobes 2010 in Accounting and Business Research, Vol 40. No. 2 pp. 173-187; and Wehrfritz and Haller, forthcoming in the Journal of International Accounting Auditing and Taxation) report that different national versions of IFRS currently exist which reflect pre-IFRS country-specific national GAAP.  What does that mean?  It means that in Australia, France, Germany, Spain, and the UK, companies that are now using IFRS, continue to use the same accounting policies they used before “adopting” IFRS which were either permitted or required by their own unique national GAAP. So much for the touted benefits of achieving comparability with a single set of global standards.  Instead, the real possibility exists that investors might be misled by the “apparent” uniformity implied by IFRS, when no real comparability exists.  So, SEC…your resolution for 2013 should be not to succumb to the political pressure of those IFRS proponents…those promoting IFRS likely do so for their own monetary gain.  If you don’t believe that, just check out the AICPA’s IFRS website and note all the training and publication opportunities promoted. Please give up on IFRS once and for all.  

The Public Company Accounting Oversight Board (PCAOB)

In a December 2012 speech at the AICPA National Conference, PCAOB Chairman James R. Doty made two huge points with which most of us would agree.  First, “high quality, independent auditing is critical to our economic success” and second, “audit firm culture must support auditors’ work.”  My hope is that the PCAOB’s New Year’s resolution will be to focus its 2013 efforts on three points: promoting high quality audit work, monitoring “real” auditor independence, and incentivizing the development of appropriate firm cultures, but with a more aggressive approach.  What do I mean by aggressive?  Check out the Grumpies’ prior rants in The Auditor’s Expectations Gap where we called for a clearer description of the “audit product” that the Big Four firms currently deliver. Ed and I also provided some clues in Who Really Cares About Auditor Rotation where we outlined some ideas on how to detect audit quality.  Another good start to the New Year would be to release all (both parts I and II) of the PCAOB’s firm inspection reports.  As Chairman Doty indicated, auditors have been inspected by the PCAOB for a decade now.  Time is up for big firm auditors…PCAOB it’s time to play hardball.

The Financial Accounting Standards Board (FASB)

The FASB’s resolution for the New Year should be not to squander their opportunity to improve the effectiveness of financial statement note disclosures via its Disclosure Framework project.  Not surprisingly, the AICPA’s Financial Reporting Executive Committee recently has raised “significant concerns” about the framework, a possible delaying tactic to preserve the status quo for the largest accounting firms and their clients.  As you may recall, the Grumpies worried about whether or not the FASB could “make the ‘hard’ decisions” in Improving Transparency in Note Disclosures.  We actually proposed a few very simple ways to improve the organization and understandability of note disclosures.  Yet, the “gurus” at the AICPA continue to be focused on form and process, rather than substance…no wonder the profession is in decline…

The Center for Audit Quality (CAQ)

This organization’s resolution for the New Year is relatively simple and straightforward: it should dissolve itself! It is no surprise that the so-called  Center for Audit Quality (CAQ) is headquartered in Washington, D.C., after all it is little more than a formal lobbying and/or marketing group for the largest public accounting firms and the American Institute of CPAs (AICPA). Interestingly, the CAQ is “affiliated with the AICPA.”  One wonders why the CAQ’s membership can’t work through the AICPA, and one of its sections or committees…why is the CAQ necessary?  If you think I am being too hard on the CAQ, just check out the “rigor” in its publications…my personal favorite is “Deterring and Detecting Financial Reporting Fraud”…long on concepts, short on detail. Maybe this is why the PCAOB is finding so many errors in its public company auditor inspections…

The Big Accounting Firms

The big accounting firms should resolve to redo their budgets for 2013.  Here are a couple of recommendations:

  • Plow the money you save from dissolving the CAQ into creating a new audit model that works.
  • Don’t build brand awareness through professional golf tournament sponsorships.  Use the monies you save to create a new audit model that works…now that would build brand awareness!
  • Stop contributing money to academic organizations and universities and invest it in something with a real payoff…the academics will continue to send you their students regardless of your funding.  Use the monies you save to create a new audit model that works.
  • Stop wasting your limited funds on student recruiting. Students will continue to seek you out for jobs because you offer the best prospect for their actually paying off their outrageous student loans.  Use the monies you save on recruiting to create a new audit model that works.

Do you sense a common theme here?

National and State Accounting Societies

Yes, this is the first time that one of the grumpies has actually picked on this poor group of accountants which includes the AICPA, Institute of Management Accountants (IMA), American Accounting Association (AAA), and a host of state CPA societies.  That’s because their situation is just so dire.  These organizations are finding it increasingly difficult to justify their existence in the face of rising costs (and dues) and increased competition for services they once exclusively offered to their members.  In short, it is unclear what the value proposition of these organizations is in today’s society.  Take the case of the AICPA.  The organization has largely been relieved of its rule-making authority by the FASB and PCAOB.  More troubling is its recent desperate attempt to poach IMA membership through its introduction of the Chartered Global Management Accountant designation.  And a quick review of its website (as well of those of most state CPA societies) reveals that this organization is mostly about publications and professional development…not even insurance sales make the homepage anymore. And membership pressures plague state accounting organizations as well, prompting them to search for ways to broaden their bases, including eliminating experience requirements to become licensed CPAs.  While this might bring industry, governmental, and academic accountants into their societies, have these organizations considered the “unintended consequences?” Most of these organizations will NOT be around in 20 years (by then the old guys in my generation will be long gone having dramatically shrunk their membership rolls).  So, in 2013 this segment of the profession should resolve to figure out how they will add long-term value to their members (which by the way overlap SIGNIFICANTLY, if not entirely).

Well, not a chance you say?  I remain hopeful for these resolutions.  After all they don’t appear on the top 10 commonly broken New Year’s Resolution list…unless you consider a “new audit model” learning something new.

This essay reflects solely the opinion of the author.

AuthorAnthony Catanach
2 CommentsPost a comment