When someone tells you ethics don't matter, believe them

If we are going to trust company financial statements, we need to trust the Auditors. As a rule, I have limited trust in Audit Partners until they demonstrate that they can make difficult decisions. Morality and ethics-based decisions. Generally, in my opinion, they fail. The most difficult choice many will make will be how low can they bid to win the business, and then how high can they push the fees in the following years and still retain the business. 

 

Last week Francine McKenna shared an article on LinkedIn: “We are all victims of Trump's fraud”. She highlighted a quote from the judge in the case: 

 

“In this particular case, in applying the law to the facts, the Court intends to protect the integrity of the financial marketplace and, thus, the public as a whole. Defendants’ refusal to admit error — indeed, to continue it, according to the Independent Monitor — constrains this Court to conclude that they will engage in it going forward unless judicially restrained.” 

 

A former Big-4 Partner commented on that post. To say that I was surprised is not exactly true, as many Big-4 and large accounting firm partners that I have known were very “conservative”, and in too many cases are simply unethical people. I turned down working for a partner because I had seen him lie on proposals. Not "little white lies” but glaring mistruths that he knew were lies. Real lies. But I digress. 

 

The comment made was "Utter nonsensical language. No one had a specific civil action? Where was this judge with Madoff?" 

 

It was, of course, a mealy-mouthed attempt to discredit the judgment against Trump, but what it really showed is how much we can, or cannot, trust that former Big-4 Partner. 

 

I fired off a response that was not very polite, then forgot about it. But it has been bothering me since. Partners sign off the Audit Reports of company financial statements, to be provided to regulators, banks, and capital markets, and via them, in effect to any retail investor. The Partners are the gatekeepers and protectors of financial markets. To “say the quiet bit out loud” is not something that they should do. They should not publicly state that unless someone can find an actual individual that they harmed, who cares, it doesn't matter, "no harm, no foul”. 

 

“Utter nonsensical language.” 

 

How many Big-4 or large accounting firm Partners hold this view? How many are so morally craven that they think their firm's signature on the Audit Report to the financial statements should carry no weight? It is just a signature, and the user of the reports should do their own due diligence; ignore the auditor's report or signature. That is not an argument for the fees they charge. After all, a Big-4 signature is supposed to tell the markets that the company is reputable and that financial processes are robust enough to withstand a rigorous audit. Further, Big-4 Partners will happily remind clients and prospective clients that a Big-4 signature will add value to their share price. 

 

“No one had a specific civil action?” Really? The new standard for company executive and auditor accountability should be whether they were subject to a “specific civil action” by an identified individual? 

 

Audit does not exist to support the client's lies. To do so makes the auditor complicit in those lies. It is a fine line between not caring about the lies and actively supporting the production of the lies (Parmalat comes to mind). That line was drawn very clearly with Andersen, eventually. The entire premise of the PCAOB is to ensure Auditor integrity, not reporting company integrity. And on the whole, I'm not confident that the PCAOB or any oversight body will alter the moral compasses of Audit firm Partners.  

 

The Mission of the PCAOB is simple. "The PCAOB regulates the audits of public companies and SEC-registered brokers and dealers in order to protect investors and further the public interest in the preparation of informative, accurate, and independent audit reports."

 

Remember that the PCAOB came into existence because auditors could not be trusted. If Auditors (and by inference Audit Partners) could be trusted, there would have been no need to create the PCAOB. After all, its name says it all, the “Public Company Accounting Oversite Board”. 

 

Sure, I've met a few Big-4 and other firm Partners that I consider to the honest and with a level of integrity that makes them, in my eyes, worthy of the public's trust. Because that is what they are supposed to do, provide the investing public with confidence that what a company reports are, barring overt fraud that was well hidden, worthy of trust. A level of trust that the public can place in the word of the Auditor. But the list is short.  

 

More frequently they give themselves away by what they say and do. 

 

This is a world in which a former Andersen senior manager and later senior partner in a “second tier” firm told me that he was successful and would be rich because “God and Jesus love me more than he loves other people". You mean like the poor or those who suffer a negative life-changing event? Yes, was his answer, the event probably happened because they didn't love Jesus enough and Jesus doesn't love them enough. Success for him did not require any moral or ethical choices, because if he did something immoral or unethical and he got away with it, that was because God loves him more than God loves others. (I'm not making this up, this was a real conversation, and yes, he is now a Senior Partner in a second-tier firm.) 

 

In the other case, the partner included in a proposal that the firm has 450 dedicated Internal Audit professionals, 150 of whom had at least eight years of experience. This was a lie. I had told him two weeks earlier that a survey of the first had identified 150 people who could spell “Internal Audit", of whom maybe 30 had eight or more years of experience. He knew it was a lie, and he put it in a proposal anyway. When asked to work for him for six months to meet an overload situation, I declined saying that I could not work for someone who overtly lied on proposals. Frankly, there was too much risk to the firm and to me that he would continue to lie to the client, putting me, the account team, and the firm's reputation at risk. The response to my statement that he lied on proposals was “he's a salesman, what do you expect”. 

In a third case, we were shortlisted to provide Anti-corruption training. But when the director of procurement at the client asked us if we could "do something for the team", we answered that we couldn't as it would breach the UK Bribery Act. It was so ludicrous that we thought it must have been a joke, or a test. A Big-4 firm won the work. I wonder to this day if they "did something for the team". Anti-corruption training.

So, to bring this back to the original statement: if someone tells you ethics don't matter, believe them. And if they tell you they support Trump, then they have proved that ethics and morality do not matter to them. Believe them. 

AI and External Audit: Not until the Business Model Changes

I’ve just read an article on AI and Audit, asking when (or if) Artificial Intelligence will take over the Auditing of companies financial statements. (“Distinguishing Hype from Reality about the Future of Automated Audits” By Gregory P. Shields, CPA, CA  http://thinktwenty20.com/images/Issues/Winter_2020.pdf)

While the article provides a fine survey of the technical issues and impediments, it misses one key element; AI is a threat to the Auditing and consulting firms' business model. Until they can determine how they incorporate this without erosion of fees and profit, there will be limited uptake.

It is an interesting article, if you are into this kind of thing, and considers three scenarios.

 

Arguably, predictions fall into three overall categories:   1. AI will soon displace human auditors. Clairvoyants in this category might be referred to as chicken littles, predicting the auditing sky will soon fall on human auditors. 2. AI will complement the work of human auditors, but never entirely displace them. These clairvoyants might be referred to as eternal optimists, looking at the future of human auditors through rose-coloured glasses. 3. AI will ultimately displace human auditors. These clairvoyants may be the realists. But, what does “ultimately” mean and what are the implications for decisions that have to be made now? (Gregory is a member of the board of directors of the University of Waterloo Centre for Information Integrity and Information Systems Assurance (UWCISA). He is also a member of CPA Canada’s Audit Data Analytics Committee. Before his retirement, he was CPA Canada Director, Auditing and Assurance Standards. His recent projects include developing non-authoritative auditing guidance on data analytics, cryptocurrencies, and accounting estimates.)

The conclusion is not surprising; that AI still has a long way to go, that regulators will take convincing, and that there remain too many cognitive processes that cannot yet be replicated by AI. These are the “value-added” that the human accounting specialist brings to the audit.

But what is missing from the article is the change required in the economics of audit to allow AI to play a meaningful role in disintermediating the human auditor.

The Accounting profession and Auditing firms exist in and rely on an economic model that will delay the introduction of full AI support for the audit. Auditing firms are highly profitable ‘consulting’ companies with a market niche that they will exploit and protect from competitors, and AI is, even if used as an ‘internal’ tool, a competitor.

Almost all major accounting firms are partnerships. While this is mostly a structural and governance mythology, they are bodies of self-feeding units that rely on a “Borg” like assimilation into a greater single entity which looks out for the collective interests. Let’s break that down. Auditing firms are like ant hives, all working together, but ready to cull the non-performing elements, and perfectly happy to jettison worker ants to protect the hive.

Each Partner owns a number of shares in the company, and those shares pay a dividend to the partners. The more shares, the greater the percentage of profits. Junior Partners “buy” a starter set of shares, and as they progress in profitability and seniority, they are allocated more shares. There are no external shareholders, and therefore no wider investor community to answer to. Certainly they talk stakeholders, but what they means are those that can impact their business model for the better or worse.

Each Partner has a team (or shares a team with other partners for efficiency) and ‘sells’ those resources to clients on specific engagements. Basically, people-hours for an agreed person-hour rate, frequently merged into a single overall rate or price for the job. At the core is that simple economics of the cost of inputs and the income generated by those inputs. Technology helps those inputs (people hours) be more productive and increases the potential price of that input on an hourly basis – because fundamentally, hours are the product.

Just as a metal stamping business many (does) use percentage utilisation of metal stamping machines as a measure of productivity, the accounting firms carefully monitor individual human utilisation rates as the core to determining productivity and potential profitability. People-hours utilised (billable) is the core of the Auditing (and associated consulting services) profession's productivity and profitability.

All other functions within the Auditing and consulting firms are paid for by the numbers of hours of human time that are sold and can be seen by the client as being delivered. The cost of delivering those hours if high. Premises, technology, HR services, and ongoing training of staff are significant costs. But there is another cost; the cost of ensuring that the profession continues to exert control over companies and their financial supply chains. After all, without a ‘clean’ audit, most companies cannot access capital at economic rates.

As an aside, brothels work in much the same way; the fundamental product is people-time, and the more time your product can spend ‘billing’ the more profitable the enterprise. Just like the brothels, if the young ones are not producing enough revenue, the young ones and the madams suffer.

A non-profitable partner or business unit within an Audit and consulting firm will be culled, and quickly. This means that a major element of the Senior Manager through Partner ranks, and especially anyone aspiring to Partner rank, is the selling of new business and the protection of and ideally expansion of fees with existing clients.

Unlike the brothels, Auditing and consulting firms have the additional costs of sustaining an industry body whose purpose is to ensure that they retain their dominance in the financial supply chain. (although I guess one could equate this to the cost of bribes to police and local officials?)

Audit firms carry the additional costs of lobbying at the international, national and state level, and through ‘ownership’ (capture is probably a better word) of the process for standards-setting. And standards that will threaten their business model will be managed. The International Accounting Standards Board (as one example) would find itself significantly less effective without the ongoing support from the major Auditing and accounting firms. The accountants and auditors provide much of the technical resources required to draft and review standards, and technical resources are frequently ‘seconded’ at no cost from the firms. And for a good reason; such secondments ensure that their people contribute to the development of the standards, it also ensures that the firms have resources with in-depth knowledge to trot out to their clients.

An AI-heavy audit is a threat to their business model. It is difficult to add a premium to the audit fee for a reduction in the amount of work that will be performed by humans. After all, if the human time is the primary cost factor, when a reduction in the total human inputs should translate into a reduction in the audit fee. Firms have been down this road before. Audit automation and through automated work-papers contributed to a reduction of the audit fee, but was offset by increases in the costs of labour and the total amount of effort required.

Sarbanes-Oxley section 404 was an excellent example. Following the Enron and Worldcom frauds, the additional requirement for a CEO/CFO certification statement resulted in a windfall to the Auditing and consulting firms, boosting total numbers of hours on audits, and the cost-per-hour of now scarce resources. First year accounting graduates were suddenly seeing offer letters at 15% to 20% higher than their friends received the year before. Internal Audit consulting firms found that they were able to raise their rates by more than 50% to 70% in a year, with that particular gravy train lasting almost a decade. It took that long to build a population of internal auditors sufficient to service the new need, in order to once again begin to push rates down.  

This is after ignoring the fact that two Auditing firms facilitated the frauds at Enron and Parmalat. Ironically, such frauds, while costing individual firms dearly, actually raised the overall revenues across the industry. In the case of Anderson’s, it destroyed the firm. In the Parmalat case, the local accounting major’s firm was expelled from the network, and their international clients in Italy were instructed to contact EY on their first day back in January 2004.

Another area where the business model will not be permitted to be undermined by actual practice is the relationship with Internal Audit. Long considered the slightly dim cousin in the auditing world, Internal Audit arguably plays a more critical role in the actual success of companies. Not only does Internal Audit provide real comfort to the Board (along with Risk Management and Management), it can also contribute to process improvement and organisational efficiency.  IA should also be able to contribute to a reduction in the cost of External Audit.

I’ve long argued that improved Internal Audit should enable the External Auditors to place greater reliance on the system of internal controls, and therefore reduce the amount of external effort and cost required to provide an audit opinion. Yet year after year, regardless of the depth or coverage of Internal Audit, the External Auditors provide trite comments about the need to confirm the quality of IA’s work, and that perhaps next year there could be a reduction in External Audit activity. Next year never comes, regardless of how thorough IA has been, or how effective management has been at the implementation of IA recommendations.

After all, effective IA is a threat to the External Auditors’ business model.

And the business model trumps any other consideration.

Artificial Intelligence will encroach on the audit, but it will not successfully do so until the Audit and consulting firms have figured out how they can incorporate it into their business models, or until their business models are changed..

 

Ethics, Audits, and Business Behaviour

So here we are again, with another corporate scandal. Who is it this week, Wells Fargo, Odebrecht, Uber, United, or someone else? The list of corporate scandals for even the past couple of years is daunting (and here, and here). Looking at the political landscape, we see the same thing, not just in the United States, but across the world. Another "breach of trust". Who would like to be dragged off the airplane today, or who would like to discover that your bank has been opening accounts in your name, that you get to pay for, without your permission?  How about that nice new bridge contract; the one that the contractor won off the back of brown envelopes, lots of envelopes?

Yet this is the reality of business today. In too many cases, the subsequent fine is significantly less than the profits from the (not proven to be criminal) activities that resulted in the scandal. Only in a few cases does the scandal result in an existential crisis for the company. Usually it only reduces management bonuses, and effectively robs the shareholders (and too frequently the customers) through destruction of share price.

Unfortunately too common following these crisis is the call for greater ethical standards. Sometimes, as happened this week with the Wells Fargo scandal, there will be calls for the audit to be improved, or the auditor sanctioned. Why unfortunately? Because such calls are meaningless.

Francine Mckenna and Andrea Riquier have written (another) strong article effectively asking "Where was KPMG, Wells Fargo’s auditor, while the funny business was going on?".  Not surprisingly, the Audit and Governance community react by pointing out that the auditor is not actually required to find or disclose non-material fraud. Nor are the auditors required to report where ethics are absent.

Pages are written about the PCAOB Auditing Standards, and the role of the Auditor. Almost all of it in defense of the audit profession. But Francine and Andrea quote Andy Green

 

“There’s been far too little attention since the crisis on how the external auditors should be looking out for the public,” Andy Green, managing director of economic policy for the Center for American Progress, told MarketWatch. They are not just bookkeepers, but the investors’, and the capital markets’ last defense against accounting manipulation and fraud.”

While extensively quoting the article, Norman Marks asks "Wells Fargo and KPMG – did KPMG fail the investors?" Actually, yes, they did. In fact, while Norman's list of things that Francine and Andrea "omitted from the article" are all correct, none of those change the fact that KPMG did fail the investors. They complied with the standards; they failed the ethical question.

Francine has a long history of taking the Audit profession to task, and while not agreeing with everything she has written, she is quite right far more times than not. The problem of course is that we do not want Auditors to tell the truth, or to opine on the ethical foundation of businesses or the individuals running those businesses.

On the one hand, they (the auditor) probably would not be able to, as they have spent so many decades as apologists for their clients. On the other hand, they would probably find that there were too few businesses or leaders that would pass a reasonable-man ethics course (based on their choices, not based on their ability to pass a test or give the "correct" answers).

Many years ago someone said to me that we didn't need more rules, we just needed better enunciated Ethical standards. I will repeat my answer:

"Ethics only apply to Ethical People".

All the ethical standards in the world will not make ethical people, especially when reward systems do not support ethical behavior. You can have all the ethical standards that you want, but fundamentally, unethical people will ignore then, and worse, will ensure that they pay for the appropriate PR to demonstrate just how ethical they and their businesses are.

I'm talking of course about people skilled in the art of managing the message. Not the bungling mouth pieces of today, who refuse to answer any question but use the time to rehearse some well scripted talking point.  I'm talking about Clive, from Telecom New Zealand (in the 1990s, so no relation to anyone there today, I'm sure).

Clive once said the secret to corporate communications was simple; "Bad news is good news, good news is no news".

While that works for managing the message, it does not demonstrate ethical behavior or even an ethical outlook, although there were a few cases where Clive most definitely was putting the positive face on what were apparently unpleasant situations.

Yet there is no way you can spin fraudulent accounts and accounting as good news. And there is no way that you can spin auditor ignorance or ignoring of fraudulent accounts as good news. There is no way that sexual harassment at the top of organizations can be spun to be good news. It is not even good news when these people are exposed, as it argues for a deeper pool of unexposed persons, all carrying on the behaviors that they have learned from their seniors (and betters?).

No, "Ethics only apply to Ethical People". For the rest there is something called "Jail time". We should stop trying to spin good news, or even trying to simply extract fines from companies. People did these things, and people should be held accountable.

If we want real Ethical behavior, then the cost of unethical behavior needs to be much higher.

That goes for Auditors as well.