Reining in the audit industry's reality distortion fieldJuly 17, 2013: 10:23 AM ET
Today, financial statements are as malleable as political promises. That's the case despite the lessons of Enron and audit firm Arthur Andersen's demise.
FORTUNE – Financial reporting in the U.S. just took one step closer to fantasy last week.
On July 8, the U.S. House of Representatives caved into the lobbying interests of the world's biggest auditing firms and passed the Audit Integrity and Job Protection Act. The bill would amend Sarbanes-Oxley and prohibit the Public Company Accounting and Oversight Board (PCAOB) from requiring public companies to change their audit firm every decade or so.
The title of the bill is pure Orwellian doublespeak. Would the act protect jobs? The bill doesn't explain. But it's likely, if enacted, the measure would protect the jobs of some incompetent auditors, and some fraudsters as well.
Would the act improve audit integrity? No. The bill rubber-stamps things as they are. With distrust a major issue hindering a full economic recovery, we need better reporting and more accountability, not the status quo. Job creation depends on our ability to revitalize trustworthy capital formation.
But today, financial statements are as malleable as political promises. That's the case despite the lessons of Enron and audit firm Arthur Andersen's demise.
Some of the plasticity relates to longstanding practices. But there's no doubt that accounting changes over the last decade that favor guesses over facts have made the situation worse. Coupled with audit firm laxity, these changes have fueled even greater manager discretion to make the numbers what they will.
Because so many of the numbers they produce are estimates, banks have always had plenty of room to fudge things. The PCAOB's Investors Advisory Group supports mandatory audit firm rotation because of concerns about the "coziness" that exists between audit firms and management, noting that "[m]any of the auditors of the large companies involved in the financial crisis ... had long running audit relationships."
Deutsche Bank (DB) is under investigation now for what allegedly may have been a $12 billion understatement of derivative losses during the financial crisis. According to a report by The Financial Times, KPMG may have signed off on accounting changes related to the alleged misstatements.
Yet at Deutsche's 2013 annual meeting, the board and investors reappointed KPMG as its auditor. A 2012 PCAOB inspection report of KPMG deficiencies cited its failures to question management judgment, including failure to test management's assumptions on loan loss reserves.
PwC has been J.P. Morgan's longstanding auditor, going back at least to 1994, the earliest records on the SEC's website. In the first two quarters of this year, J.P. Morgan (JPM) has garnered the attention of Fortune and CNNMoney columnists as the bank boosted earnings by lowering its estimates of loan losses. Last year, J.P. Morgan's provision for loan losses was all over the map with a low of just $200 million in the second quarter, coincidentally when most of the London Whale charges reportedly happened to hit. The provision then rose to a high of $ 1.8 billion in the third quarter, sandwiched between $700 million in each of the bank's 2012 first and fourth quarters. This year, the difference between quarters has also been dramatic with the bank's provision estimate for second quarter dropping sharply to less than one-fourth of last year's quarterly low.
In 2010, the PCAOB issued a report on PwC's failure to address previous criticisms, which included statements about its overreliance on what management said and a failure to test information related to a company's loan loss allowance. A 2012 inspection report by the PCAOB raised similar concerns.
Because estimates are so often based on management whims, a little-noticed $3.5 million settlement between the SEC and Capital One in April stood out. Ernst and Young has been Capital One's (COF) auditor since at least 1997, the earliest year that financial firm's proxies are available on the SEC's website. In this case, the SEC accused Capital One of using loan loss reserve estimates from October 2006 through the third quarter of 2007 to understate the financial firm's auto loan losses.
According to the SEC, Capital One's auto loan charge-offs at the time were increasing. This should have been a red flag to Capital One's audit firm at the end of 2006 that the loan loss reserves in the auto portfolio needed to increase. So where was E&Y?
You might expect Capital One's audit committee to fire E&Y after this debacle. But how independent can E&Y be after working with Capital One for over 15 years? In the worst case, the auditor looked the other way to let management do what it wanted to. Neither E&Y nor Capital One returned requests for comment.
In May, the PCAOB disclosed that E&Y had failed to make sufficient efforts to address previous PCAOB criticisms, which included, among others, "apparent failure to appropriately challenge management" and failure to test loan loss reserves. A 2012 inspection report of E&Y echoed similar concerns.
In addition to mandatory audit firm rotation based on tenure, perhaps SEC settlements like Capital One's should include mandatory audit firm rotation or dismissal. Such a practice could provide additional incentives for audit firms like E&Y to follow up on the PCAOB's critiques and scrutinize client's financial reports more carefully. Greater transparency so investors know which companies have had weak external audits could also provide a helpful shot in the arm.
Too often, audit firms get off scot-free. In May, Alabama state court ruled against HealthSouth (HLS) in its suit against Ernst and Young, the company's auditor at the time of its major fraud. KPMG and E&Y escaped in the Olympus scandal.
Ernst and Young, which is also HP's (HPQ) auditor, has skirted responsibility so far in the Autonomy merger, despite conflicts that have bothered investors. Change to Win Investment Group had recommended a no vote on E&Y at the firm's annual meeting this year.
Low audit firm quality has helped fuel board member concerns about firm rotation, claiming, "the devil we know is better than the devil we don't." But last week, I met with a director who has had a change of heart. After having to deal with a major accounting restatement, this audit committee chair now thinks mandatory audit firm rotation would be wise. The audit firms are still too close to management, this director says.
Other board members would likely change their minds if audit firm rotation became mandatory. When listing standards changed in the wake of Sarbanes-Oxley, board members who complained publicly about the proposals were happy for the cover the requirements gave them to meet without executives present. Directors are often reluctant to switch auditing firms out of fear that a new firm will not do an effective job. Mandatory audit rotation would apply much-needed pressure for audit firms to train their staff to take on new clients efficiently.
But a bill that would circumscribe the abilities of the PCAOB will not promote audit integrity nor protect jobs worth saving. In April, the Legal Affairs Committee of the European Parliament voted for a weak form of mandatory audit firm rotation that would "require public companies to change audit firms after up to 14 years, which could increase to 25 years if safeguards are put in place," according to a report by Accounting Today.
We are in a global marketplace for capital, and others are moving forward. We can't afford to bind our own feet and lose our position in the race.
Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board education and advisory firm.