I am trying hard to be optimistic, but there are more than a few indications that a Senate investigation of the accounting profession's role in the economy – which began last week with a two-hour hearing by the Subcommittee on Securities, Insurance, and Investment – will fizzle out before it gathers momentum. But, there are also reasons for hope.
The formal title of the hearing was "Role of the Accounting Profession in Preventing [Yet] Another Financial Crisis." Each of seven panelists were given about 10 minutes to make an opening presentation and to answer a few questions, mostly coming from the subcommittee chair, Jack Reed, Democrat from Rhode Island. Notably, not a single question came from Republicans; in fact, nary a one so much as deigned to attend.
There's politics for you, that not even a mother could love. Yet, I am encouraged somewhat that at least a few lawmakers are ready to fight the good fight. There were certainly some stars at the hearing, but even without the boycotting Republican senators, the hearing also had its share of goats.
The first star of the Senate hearing goes to James Doty, PCAOB chairperson. To appreciate just how important he was to the proceedings, imagine if he were replaced by some implacable apologist from some stonewalling AICPA committee. Were it not for provisions in S-OX that established a PCAOB to be governed by non-accountants (see S-OX sec. 101) that's the sort of audit profession leadership we would have. Doty is also being backed by what could be emerging as the most formidable and influential investor group, the PCAOB's own Investor Advisory Group, which certainly would not exist without S-OX.
Unlike the FASB, which seems to studiously ignore the protestations of its own Investors Technical Advisory Committee, Doty appears to have taken to heart the recent scathing indictments of auditors by the PCAOB's IAG. The most telling moment of the hearing was Doty's unequivocal acknowledgement that auditors should have delved deeper into valuation, going concern and end-of-period issues before issuing their clean opinions on financial institutions that ultimately disintegrated in one way or another. Moreover, these auditors lacked the independence from management to go to them or the audit committee to sound an alarm, even if they suspected a problem.
The protestations of another panelist notwithstanding, which I will get to below, there is no getting around the fact that audit failures played a significant role in the financial crises. But, while Doty's commitment that the PCAOB will look at the auditing model, which "has not changed in more than 60 years" is encouraging, there are indications that the PCAOB's project will not be as comprehensive as it needs to be. As I stated in an earlier post, merely changing the language of the audit report, and/or supplementing it with additional disclosure prepared by the auditor cannot be expected to fundamentally change audit effectiveness. Nothing less than a fundamental reassessment of the role of auditing in public company financial reporting can begin to accomplish what is needed after the three auditing Armageddons in three decades: the S&L crisis, Enron et al, and the 2008 financial crisis.
The second star goes to Senator Reed, who teed up the issues rather well in his opening remarks and questioning. Capital markets need effective audits, and the receipt of unqualified opinions by all of the major financial institutions in the period leading up to their demise has, only a few years after S-OX, raised the same questions regarding auditor independence, audit scope, and ultimately whether a clean audit opinion provides valuable information to capital market participants.
Reed didn't say this explicitly, but I think the subtext of his questions were this: it's one thing to say that the fundamental causes of the financial crisis was poor decision-making by managers; but it must also be asked how deficient accounting and auditing rules facilitated those actions. The disintegration of major financial institutions did not occur from a single blow, and warnings had been issued by numerous credible commentators. Yet, none of these seemed to have registered sufficiently with auditors and regulators. The apparent result is that all of the financial statement revelations of value destruction that was years in the making arrived too late to be of much benefit to investors and bank regulators.
The third star belongs to Lynn Turner, the last panelist to give his prepared remarks. Don't just compare Doty to the hack who would have sat in his place absent the PCAOB. Compare Lynn Turner, a former SEC chief accountant himself, to the current chief accountant, James Kroeker was obviously standing in for SEC chair Mary Schapiro. Schapiro would have risked revealing her ignorance of accounting and auditing if she had attended. As for Kroeker, stand in is just what he did; he might have had more affect on the hearings if he were an ashtray.
Turner observed, as Kroeker should have and with more than a trace of resignation, that the questions being asked that morning haven't changed for the last 25 years. The FASB has consistently failed to issue timely standards that work; and it should at least be requiring additional disclosures to when adherence to a rule results in misleading financial statements (think, for example, Lehman's repo transactions). Under the rules that we have, banks failed to report losses that had been incurred over a number of years, and the standards to limit off-balance sheet accounting have failed. Audit committees are not as engaged as they should be, and the SEC has been more like a lapdog than a watchdog.
To the Goats We Must
After Bob Herz was relieved of his duties as chair of the FASB – because he (rightly in my estimation)believed in reporting the fair value of loans and separating the informational needs of investors from the needs of bank regulators (my opinion) – the job of leading the FASB devolved to Leslie Seidman. The hearings hit rock bottom no less than three times while she was speaking.
First, Seidman's opening remarks were a waste of time. They were a by-the-book and useless overview of the FASB and the FAF, and an empty defense of independent standard setting. In other words, everything is under control; the SEC should remain the lapdog while the FASB fiddles, postures, and caves to special interests through some amorphous protocol masquerading as "due process." I am truly sorry to have to report my impression that, in comparison to Doty, Seidman was the bland bureaucrat, lacking energy, vision and no apparent purpose higher than self-preservation.
Second, Reed asked why the FASB had not eliminated the abuses from accounting for off-balance sheet transactions, as directed by S-OX? The best that Seidman could say was that the changes that had actually been made were an "improvement" over the standards that existed at the time. But, Reed wanted to know why OBS tricks couldn't be fixed and dealt with more comprehensively, as Congress intended?
No help. And, of course, Seidman did not volunteer that off-balance sheet lease accounting is, almost ten years later, still alive and well, and available for abuse.
The third nadir was plumbed when Seidman chose not to respond to Senator Reed's concerns about whether auditing is just a loss leader for other services, or whether the fear of telling truth to power will find the auditor out on the street. To the obvious bemusement of Reed, Seidman demurred on the basis that auditor backbone was not something she knows about – even though she worked as an auditor, and as an assistant director of implementation and practices at the FASB.
Cynthia Fornelli, executive director of the Center for Audit Quality is my second goat (or maybe even tied with Seidman) for stating with a straight face that "everybody agrees" that this was not a crisis caused by auditing and accounting; and following that up by suggesting that auditors could help prevent another financial crisis if they were to attest on more than just the financial statements. Such a notion had been more or less summarily rejected by the SEC shortly after the S&L crisis. A few years later, the AICPA did promulgate a set of attestation standards that would cover MD&A, in hopes that some companies would voluntarily purchase an attestation report, but I know of not one company to have done so.
Most bothersome to me about Fornelli is that the substance and tone of her remarks foreshadow a pitched battle with any reforms that Jim Doty's PCAOB might attempt. She leaves little doubt that the CAQ will strenuously lobby against any proposal that could take money out of the pockets of auditors. While the PCAOB will be making a good faith effort to understand how the accounting profession contributed to past failures in order to find a way forward, don't count on the accounting profession to do anything except to erect roadblocks.
The Prospects for the Future
Taking the remarks of Turner and Doty together, the subcommittee cannot escape the conclusion that financial reporting is broke, and what's worse, key stewards of financial reporting are either misguided or dysfunctional.
On the bright side, Jim Doty, if his skin is thick enough, could make history at the PCAOB. But, without an SEC renaissance and a fundamental reform of accounting standards, a reform of auditing standards can't possibly be more than a half measure.
I wish I could be more optimistic.