The Relevance of Audits and the Needs of Investors

This is a special year in many respects. We have our own concerns at home. But those of us who find our work on financial terrain have our sights trained east, toward Europe, and west, toward China, more than in past years.

In the broader population, there is new apprehension for effects we don’t know but must nevertheless judge. Will European states muster a defense to the behavioral contagion of financial panic? Will they find a way to use their inter-dependence to make Europe financially stronger? Or will they find that too many divergent interests must agree to save the European experiment? How will the U.S. be affected?

Looking toward China, many say that that nation’s economic growth cannot continue without structural changes. Can China instill its new, investing middle-class with confidence that financial markets will provide for its future? From our larger companies to our smaller entrepreneurs, we are doing business in China. Can we have confidence that China isn’t the latest iteration of — pick your era — the Tulip Scandal, the silver-mine frauds of the Old West, the S&L bust? And how should we deal with these risks in a global economy?

These are questions that require that admirable quality we often call vision. When we speak of vision, we speak of visionaries. That is, people who have stepped out from the crowd and revealed something that the rest of us could not see. There are false visionaries, who inspire us to act based on what we or they wish might be. But the true ones give us honesty, and invaluable leadership.

I. Ken Leventhal Exemplified the Expertise and Integrity that is Needed to Make Accounting and Auditing Relevant to the 21st Century.

Earlier this month, the University of Southern California, the accounting profession and the public more generally lost a true visionary. I refer to the passing from our scene of Kenneth Leventhal earlier this month, at the age of 90.

Ken Leventhal, throughout his career, gave us clear ideas about how the practice of accounting can and should give society the tools necessary to reduce complicated circumstances to simple, actionable facts.

And he was a good Trojan. Although a graduate of UCLA, he became an active and generous USC supporter after UCLA ended its accounting major. He believed in the future of the accounting profession. He wanted to train the new generation of accountants to use the tools he had developed in practice to help the profession thrive as a vital force for social good.

He helped build and maintain a first-rate accounting program at USC, which among other things brings the faculty, policy-makers in accounting, auditing and securities regulation, as well as leaders in the profession together each year at this first-rate conference.

Beyond his work here at USC, his professional life leaves a great a legacy and, if we heed his lessons, perhaps a chance to see our confusing financial world with his clarity. He was born in 1921. As he told his own story, he got the idea for his career when he was a paper boy for the Herald-Express newspaper.

His boss was planning to take a correspondence accounting course and go into business for himself, because — as many faculty members will likely recall Mr. Leventhal recounting — “all it took to get started in accounting was a pencil.” Mr. Leventhal said that “for a nickel,” he figured he could be his own boss, and he never changed his mind.

Mr. Leventhal’s plan was interrupted in 1939, after high school, by WWII. When he returned from the war, he enrolled at UCLA on the GI Bill. That is where he met his wife and future business partner, Elaine Otter Leventhal. After they finished school in 1949, they started the accounting firm Kenneth Leventhal & Co. in Los Angeles. They focused on real estate accounting, and grew the firm into the premier real estate specialty firm in the country, at one point the ninth largest firm in the country.

Their clients included the top real estate developers in the post-war period — Ray Watt, Trammell Crow, Donald Trump, and Donald Bren to name a few. Mr. Leventhal made his mark guiding those clients “through times of expansion and financial distress.”

To give you a sense of that mark, let me read a passage from a Washington Post article in 1990. It said, “When Donald J. Trump, the flamboyant real estate tycoon, found his business empire in disarray, he could have called on any of Wall Street’s top investment bankers to help him out of his troubles. Instead, he turned to an accountant in Los Angeles,” Kenneth Leventhal.

The Post called him “no run-of-the-mill” accountant. Rather, it reported, “[a]t a time when the world of accountants and their firms is undergoing wrenching changes, besieged by government lawsuits and cutthroat competition for clients” — sound familiar? — “the 70-year-old Leventhal is running ahead of the pack and, so far, ahead of his profession’s problems.”

The Post went on to explain the source of his worth: his skill and integrity. As one person put it at the time, “If Trump said his properties were worth such and such, the bankers might not believe him. But if Ken Leventhal says they were worth it, nobody would challenge his word.”

For decades, the firm had enjoyed high regard in accounting and real estate circles. Forbes magazine noted in a 1979 article on the firm that, through its expertise, “Leventhal . . . made a name for itself by helping over a score of troubled real estate companies keep out of the courts.

The Leventhal firm specialized and trained its professionals in being able to discern, in simple terms, the economics of transactions. In putting together a debt-restructuring plan, for example, the firm “first had to cut through what Leventhal call[ed] ‘the accounting hogwash.'” As a long-time partner explained it: “What we do is analyze the underlying real estate in terms of a range of values, under different economic circumstances. And we look at the probable streams of cash flow.”

In other words, he eschewed over-reliance on manuals and complex programs that tried to anticipate everything, but, in the end, could be used to excuse a failure to find the proverbial needle in a haystack. This is not to say that the global audit firm can do without structure and manuals, or that our economy can dispense with the global audit firm.

But Mr. Leventhal’s career exemplifies confidence in a guiding principle — one that encourages staff to simplify, to understand the economics of a transaction before attempting to apply the accounting requirements. Doing so requires a deep understanding of the prevailing circumstances, awareness of trends, acute sensitivity to the fact that even the best managements have an inherent bias toward self-protection. As he said, it can be done with a pencil, and the will to be skeptical of false visions. That is, the will to get it right.

The approach an accountant chooses makes an enormous difference, to the investors that rely on his work, to his firm’s integrity and reputation, and even his own career. One of the most exciting things about a career in the accounting profession is that, no matter where you are in the country, your work — and your choices in how to perform that work — can make an immense difference to an enormous number of people. That’s also, of course, a daunting responsibility.

II. An Audit Establishes Its Relevance on a Foundation of Skeptical Inquiry.

An audit that is merely confirmatory, that supports management’s vision without sufficiently testing it, promotes commoditization of the audit, and it does worse. From the halls of the great marble buildings in Washington, from the skyscrapers of Manhattan, from the sunny gardens here in Pasadena, one hears the same refrain: the complexity of financial reporting makes it difficult for management to report, auditors to audit, and investors to understand the economic substance of a transaction or event.

This tropism — our inexorable tendency toward the complex — threatens to crush auditor, preparer and investor alike. But the truth is that, by their conduct, auditors may encourage complexity by failing to simplify transactions to their economics, by approaching their task as steps in a corroboration, by failing to speak to the realities and relying on the formalities.

Leventhal’s accountants saw this first hand in a classic instance of Mr. Leventhal’s so-called “hogwash.” This example started out in a little known savings and loan association in Irvine, California, which was acquired by a hungry and ambitious real estate investor in Phoenix. It burst onto the public stage when the Leventhal firm’s work was pitted against the work of three major accounting firms.

Leventhal had been engaged by the federal government to examine transactions in which thrift regulators paid certain bankers to take on ailing institutions in exchange for more than $50 billion in federal subsidies. The firm helped the government determine which transactions should have been reopened or renegotiated to win better terms for taxpayers.

In July 1989, the firm produced a report for the Federal Home Loan Bank Board of San Francisco on Irvine-based Lincoln Savings and Loan Association. The Leventhal report studied 15 transactions undertaken by Lincoln in 1986 and 1987.

The report stated that —

The transactions . . . analyzed were accounting-driven “deals” created for the appearance of profits. In economic reality the transactions provided no profit, but instead exposed the Association to huge economic losses from other linked transactions or side deals, which the Association entered into for no apparent reason other than to induce purchases of its real estate at prices far in excess of appraised value.

The report concluded, “Lincoln was manufacturing profits by giving its money away.”

The report ignited a political and public firestorm. It was the basis for federal regulators’ decision to put Lincoln into receivership in August 1989, costing taxpayers more than $2 billion — still a large sum today.

It was also submitted to the House Banking Committee, which had commenced an investigation of Lincoln, its parent American Continental, and Charles Keating, who headed them. At the Banking Committee’s hearing on the matter, representatives from one of the three national accounting firms that had audited and signed off on Lincoln’s accounts in recent years challenged the conclusions of the Leventhal report —

These matters were complex, and judgmental decisions were sometimes necessary to determine which accounting rules applied and how to apply them. We strongly disagree with Kenneth Leventhal’s sweeping generalization that we elevated form over substance. In its review of just 15 Lincoln and American Continental transactions, out of hundreds of transactions, Kenneth Leventhal has made some serious mistakes.

The Leventhal representative responded that “by properly reversing [the fifteen transactions they studied], over half of Lincoln’s reported profits since Mr. Keating acquired the association disappeared.”

Many of the deals included related party transactions, in which Lincoln or its parent, American Continental, provided the needed cash down payment to purchasers of Lincoln real estate either through a circuitous loan or by buying other real estate from the purchaser.

The arrangements allowed Lincoln to report taxable income that exceeded the consolidated taxable income of the parent, allowing Lincoln to make cash payments to the parent, American Continental, in the guise of the subsidiary’s portion of American Continental’s tax obligation. To keep all this going, Keating exerted extreme pressure on Lincoln’s and American Continental’s auditors, the banking regulators, and even the Congress, which produced its own scandal in the Keating Five. Meanwhile, Lincoln, the regulated savings and loan, was drained.

Contrast the paradigm offered by the Lincoln auditor —complexities and the need for “judgmental decisions” — with the Leventhal approach: relevance achieved not by accepting complexity but by pursuing clarity, for its unwillingness to accept form over substance. The Leventhal approach made accountants’ work useful for clients, pertinent to the economic environment, and beneficial to the public. Based on what the Leventhal firm had uncovered, in 1989 the Chairman of the FDIC said that the government should have moved three years sooner to take disciplinary action against Lincoln.

III. Indications of Future Challenges and a Path Forward

Until his death, Ken Leventhal exhorted the profession to excel in quality, integrity and expertise. He believed those are the ingredients that, if championed, will make the profession vibrant and successful in the 21st century.

In 2010, after the most recent financial crisis, he said, “The thing that bothers me nowadays is reading about all these accounting problems and ‘irregularities.’ I’m worried about the standards of our profession that would allow all these ‘irregularities’ to occur. I think we need to teach accounting students and younger staff a greater obligation to integrity.”

A. Inspections Continue to Reveal an Unacceptable Number of Deficiencies.

Ken Leventhal was right to recognize that, notwithstanding his optimism for the new generation of accountants and his belief in the importance of accountants’ work to the success of our capital markets, there is unfinished business to resolve the contradiction between the audit as a confirming exercise and the audit as an inquiry to arrive at the truth — the contradiction between the corporate client the auditor sees (and whose view may determine the success of the individual’s career) and the investor client (whose view determines the success and continued relevance of the profession as a whole).

The PCAOB has conducted annual inspections of the largest firms for the last nine years. We also conduct inspections at least once every three years of other firms that audit, or play a substantial role in auditing, companies that are considered issuers in the United States. This includes some very large non-U.S. firms that are affiliated with the large U.S. firms, as well as many smaller firms, both U.S. and non-U.S.

Each year, we have deepened our understanding of the firms’ issuer audit practices. From the beginning, inspectors have identified numerous deficiencies. These are situations where inspectors believe, after considerable dialogue with the firm to agree on the facts, that the firm has failed to obtain sufficient audit evidence to provide a basis for an audit opinion. In such cases, the financial statements may well be fairly presented in conformity with GAAP, but the audit work was not sufficient to obtain reasonable assurance that they are.

I believe the rigor of inspections has improved the quality of auditing. Our inspectors have noted some significant improvements, such as more care in certain areas and clearer thought-processes as reflected in audit plans and audit conclusion memos. Yet, in recent years, we have seen an equally significant spike in deficiencies.

Year in, year out, inspectors find deference to management in key reporting areas. For example, in the critical area of fair value reporting of financial instruments, instead of skeptically testing the reasonableness of managements’ assumptions and resulting assertions, one firm’s method involved obtaining valuations from a number of external parties and picking the one that is, “closest to the pin” — the pin being management’s claimed value.

The work and expense to obtain the various outside valuations may have created an appearance of rigor. But the explicit acknowledgement that the test was designed to support management’s number — the “pin” — calls into question whether the auditor approached the audit with appropriate skepticism. What about evaluating management’s estimate in light of the environment and prevailing trends? What about looking for the value that is probable in light of those trends?

It is the rare case in which an auditor knowingly acknowledges or documents the conflict between maintaining objectivity and maintaining a good client relationship. Indeed, the auditors who explicitly aimed for the number closest to management’s claimed value may not have consciously sought to obscure valuation errors.

Nor am I suggesting that Lincoln’s auditors colluded with management to mislead. But they did allow themselves to be mere corroborators of a story that became thinner with each transaction.

Lincoln stands as a vivid reminder that auditors who merely confirm managements’ estimates and don’t challenge them with the basic tools at their disposal may have squandered a chance to avert later investor ruin: they run the risk that the company’s estimate was unreasonable when made.

Auditors have clients to keep and practices to grow. Recall the pitches some auditors have made to win audit clients. For example, commitments by the engagement team to “support the desired outcome” when matters need to be vetted with the firm’s National Office. Or to offer “a reduced footprint in the organization, lessening audit fatigue.”

Recall, also, the troubling notes in some auditors’ personnel files, in which the reviewed auditors claim to have advanced cross-selling of non-audit services, raising the question whether firms’ cultures still impliedly encourage auditors to sell services to their audit clients and, if so, legal or illegal, whether such goals undermine the appropriate state of mind for auditors.

This is the unfinished business that occupies the PCAOB, and occupies audit regulators around the world who have also identified a gap between the purpose of the audit and its fulfillment. These concerns have been expressed by regulators in Canada, Germany, the U.K., the Netherlands, Australia and elsewhere. The gap threatens the future relevance of the profession’s work, as well as public confidence in its credibility.

B. The PCAOB’s Initiatives Aim to Help the Profession Realize Its Potential by Enhancing the Relevance, Credibility and Transparency of the Audit for the Sake of Investor Protection.

The PCAOB is deeply engaged in examining ways to enhance the relevance, credibility and transparency of the audit to better serve investors. Our projects include improvements in basic auditing areas, such as what to look for in transactions involving related parties, including corporate executives. The PCAOB proposed a new auditing standard on related party transactions on February 28. Comments are requested by today.

This standard describes basic tools that good auditors have used for years to identify financial reporting risks. Among other things, it requires auditors to understand management’s compensation as a way to understand management’s motivations. Indeed, changes in performance metrics may well be an important clue to understand areas where management’s story is weak. They offer the auditor insights that may not be gleaned otherwise.

The PCAOB has also recently proposed, for a second exposure, a new auditing standard on what the auditor should communicate to audit committees in order to protect the public’s interest in keeping audit committees informed of important audit matters. In addition to receiving written comment, the Board has held a productive public roundtable discussion on auditors’ responsibilities to audit committees. I expect the Board soon to adopt a final standard that reflects the public advice and comment.

The PCAOB standards-setting work also includes more broad-ranging projects, commenced not with concrete proposals but with concept releases, to examine ways to enhance the relevance, reliability and independence of audits in today’s world, and in light of lessons both auditors and investors have learned in the recent financial crisis, not to mention past crises that like Banquo’s ghost haunt us still. These projects involve consideration of changes to the form and content of the standard audit report, as well as a deep examination of the behavioral patterns that the current audit model imposes.

I am not here today to tell you where the PCAOB should come out on the question of what is the most relevant information auditors should provide the investing public. But I do believe that the investing public can and should benefit from the wisdom of auditors like Ken Leventhal.

I am interested in a better, more transparent reporting model, that will align auditors with investors, that will make the audit more relevant, de-commoditized, and that will function to more consistently require auditors to demonstrate the requisite skepticism and provide true insight.

The project on independence invites discussion on ways to relieve auditors of the pressure both to foster and maintain a long-term relationship with the audit client when making tough decisions on an audit — to relieve auditors of the tie between their engagements and their careers. In this regard, as with the revisions of the auditor’s reporting model, the focus of the European Union and its member states becomes a factor in our own process. There, the perception grows that something is likely to change.

The EU and its member states are engaged in a process that, I suspect, will take them through 2013 and into 2014. What we are learning through roundtables and public meetings on our concept releases is highly relevant to their process. How we internalize, how we digest, what we hear in our debate, will inform the debate and process of policy development in Europe.

This is not an easy subject. Some form of term limits may or may not provide more independence: but I believe we must explore the possibility that they would help and the feasibility of the range of approaches available to free the auditor to think and act more independently.

C. The Global Nature of Auditing Today Requires Enhanced Attention to Address Risks to Investor Protection.

I could not close a discussion on the future of auditing without reflecting on some other aspects of the international dimension. All of the challenges and initiatives I have described must be understood against the backdrop that auditing today is a global endeavor.

Firms large and small have chased, and then fled, the plethora of potential Chinese and other non-U.S. clients seeking to draw from the wellspring of U.S. capital markets. There are lessons that could be learned, that should have been learned, from the S&L crisis and the internet bubble. Auditors’ choices are the same, but the outcome could be even worse.

In the S&L crisis, the U.S. government turned to the profession to sort out the facts and provide reliable valuations of assets. Who will be the Ken Leventhals of today?

Last week, faced with a similar task, the Spanish government announced that it had chosen a different path. It has eschewed the work of auditors in favor of a different kind of analyst. The financial statements the government questioned were audited. Is the auditor’s work not relevant today? The only thing worse for the profession than being involved in the next banking crisis may be not being involved in it.

Through their networks, audit firms reach everywhere. Local environments and trends are within their long reach. Engagement partners supervise audits that span continents and oceans.

But the reader of an audit report may not know how much of the actual work was done by the firm signing the report. Participating audit firms practice in markets that exhibit markedly different business cultures, with divergent patterns of transparency.

Small U.S. firms around the country are also engaged in audits of foreign private issuers, or U.S. companies that operate, in Asia, Latin America, Africa and elsewhere.

The PCAOB is focusing on the effect of these various business models on the protection of investors. In any given week, PCAOB inspectors are working in numerous countries, often side-by-side with local audit oversight authorities in joint inspections. We are drawing as broad and as clear a picture as we can about how auditors meet the challenges of understanding different environments and coordinating with other auditors to obtain a full grasp of a company’s true results and financial position.

We have identified a number of deficiencies in multi-national engagements. Some of the auditing issues have been related to particular areas such as revenue and fair value. Others seem to be attributed to a failure to adhere to the instructions provided by the principal auditor. The director of our inspection force is here today to discuss them.

I am also concerned that the public knows little about how audits are conducted. In this regard, the PCAOB proposed last fall new requirements to disclose to investors how a multi-firm audit was accomplished. I expect to ask the Board to act on it in the near future.

With sunlight on how the audits are done, they may improve in coordination and quality as well. If darkness persists, I fear some auditors will find themselves on the wrong side of the debate when the lights go on and they are called to account for how a fraud could have eluded a vast network of soldiers in what is supposed to be a fight for truth. These are choices we make today, but will need to explain tomorrow.