Friday, November 10, 2006

We Have Problems with the Auditors? Who’s “We” Kemo Sabe?

Fred Whittlesey
Compensation Venture Group, Inc.

As you may have deduced from my posting Peek-a-Boo I See You (and your Black-Scholes assumptions) on 23 October 2006, I have some issues with the Public Company Accounting Oversight Board’s positions about option valuation. (This is minor compared to the position of some, like Ken Starr, who has issues with the mere existence of PCAOB.) PCAOB’s comments about assumptions used in option valuation and how these might represent fraud, of course, occur in the context of the many companies under investigation for so-called option backdating and whether those companies engaged in fraud.

As you may know, many of these companies have been found to be guilty of nothing more than administrative inefficiency, poor documentation, and other procedural (remember that term, “procedural”) shortcomings resulting from an emphasis on running their business – you know, customers, products, things like that – rather than administrative processes. Not ideal, but hardly evil.

How interesting, then, the article in today’s Wall Street Journal titled “Accounting Watchdog Falls Behind” which says “The regulator that oversees accounting firms has fallen behind in a key task: issuing inspection reports on how well the country's biggest firms are doing in their work auditing public companies.” Well, “so what?” you might say. Everyone falls behind sometimes, right?

But we should at least ask why. “The oversight board didn't give a specific reason for the lack of any Big Four inspection reports this year” says the article. “Rather, procedural issues related to the inspection process are at play, said PCAOB member Daniel Goelzer.” Ah, procedural issues.

It seems that there are all sorts of reasons that the PCAOB doesn’t get their work done on time. “He (Mr. Goelzer) said the board's inspectors can't begin their work until May of any given year, when auditors typically finish looking at clients' previous-year results. Also, the agency must take time to see that the inspections process is consistent for the different firms. Another possible delay: In some cases, an inspection raises issues that require the auditor to bring the company whose books were being audited into discussions with the PCAOB.” Maybe they also got a flat tire on the way to the meeting, or the sun was in their eyes, or their dog ate their report.

There was no mention in the article of the PCAOB being investigated over this even though it says “Investors and corporate board members say the increasingly long delay in seeing inspection reports is compromising their usefulness and make the board less relevant. This year's PCAOB reports on the Big Four will cover inspections done in 2005 of audits the firms conducted of 2004 financial results.”

The real kicker here? Remember that little or no public questioning has been done so far about the auditor’s role in the so-called backdating situations. Dozens of executives have lost their jobs but I haven’t heard of any auditors losing theirs. So this next comment in the article is particularly interesting: "’The inspection reports provide greater transparency into the audit firms, but from an investor and board member perspective too much emphasis is placed on the past,’" said Donald Nicolaisen, a former chief accountant of the Securities and Exchange Commission who now sits on the boards, and audit committees, of three U.S. public companies including Morgan Stanley. "’We know there were problems [with the auditors] three or four years earlier. The real question is how are they doing today?’"

“We” know there were problems three or four years earlier? This of course raises the oft-quoted joke in which the Lone Ranger, caught in an ambush, turns to his sidekick Tonto and says, "Looks like we're surrounded by Indians." Tonto replies, "Who's ‘we’, kemo sabe?"

Maybe Mr. Nicolaisen means that “We, at the Securities and Exchange Commission” knew there were problems with auditors three or four years ago. Let’s see, 2006 – 3 = 2003; 2006 – 4 = 2002. Isn’t that post-Sarbanes-Oxley? And there were still “problems with the auditors.” Maybe he is implying that “we” includes all those who relied on auditors’ guidance, opinions, and signatures on financial statements. Or perhaps this is the “nurse’s ‘we’” (known formally as the “patronizing we” – and Mr. Nicolaisen is saying that “you” knew there were problems with the auditors.

What does “kemo sabe” really mean, anyway? Some say it is “Apache friend” or “trusty scout.” Another theory is that it is a mischaracterization of “qui no sabe” which roughly translates from Spanish as "he who knows nothing" or "clueless." I am one who knows nothing about the Spanish language so I’ll have to take someone’s word for it as I am clueless.

The Tonto line is pretty funny, if you assume the last of those interpretations, as it was likely intended to be. What’s not funny is that the PCAOB is not being held to the same standard of perfection against which over 100 companies are being evaluated. Late? No problem. No document? No problem. Maybe the PCAOB can just backdate their report so that it appears that they completed their work on time. (Ouch.) Someone here is clueless and “we” need to identify who that is, kemo sabe.

Fortunately, the PCAOB may be a non-issue in all of this as the SEC is responsible for enforcement. As Harvey Pitt, former Commissioner of the SEC, said in an interview with the San Jose Mercury News on 17 October 2006 regarding the option backdating issue “The SEC is showing a great amount of balance in how it approaches these issues. It's not rushing to make headlines. It's proceeding in a way that is thoughtful and appropriate. That is the hallmark of good regulation and good enforcement.”

But to the extent the PCAOB influences the regulatory zeitgeist they need to be held to the collective standard of excellence or they're just not being a trusty scout.

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