Requesting a do-over

First published 20 March 2006.

I am in general a booster of business, be it small, medium, or large.  I harbor no particular ill will toward the left’s pantheon of evil Canadian big businesses—banks, insurance companies, retailers (especially Wal-mart)—suspected of fleecing their unwitting customers left, right and centre.  I accept rational self-interest as a good and decent motive for commercial enterprise, per Adam Smith:  “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.”

Sometimes, however, companies can be blind to their rational self-interest.  Enron and MCI WorldCom are notable examples; for while the executives thought they had served their own selfish ends, in reality it served no-one’s interest for the whole company to go bankrupt and for the executives to be indicted.  These flameouts were spectacular and tragic, but they are also an aberration, not the norm.  Most companies go about their business without crooks at the helm, although they can, occasionally, be tone-deaf to public perception and earn a nasty reputation.  Sometimes the tone-deafness reaches heights that astound even their cheerleaders in business media.

    Nortel Networks Corp. has faced years of financial statement restatements, accounting crises, a roller-coaster stock price, and changes to executive management, but throughout it all, Deloitte and Touche LLP has been a constant.

    Deloitte, the world’s biggest accounting services firm, has held on to the Nortel account even in the company’s darkest times.

    During Nortel’s restatement years, Deloitte was paid $57-million in 2004 and $72.7-million in 2003 — for what amounts to the largest fees in those years for audit, tax and related services paid by any Canadian company.

    But after Nortel’s decision last week to restate its accounts for the third time in as many years, the issue that’s puzzling many is how Deloitte has held on to the Nortel account.

    — Duncan Mavin, “How Nortel, auditor became joined at hip
Financial Post, 17 March 2006.  [emphasis mine]

Indeed.

From Nortel’s perspective, having to restate earnings is a negative, but not unheard-of.  Having the same auditor conduct a review of the restated earnings will undoubtedly cause some grumbling amongst the shareholders, who will be justifiably skeptical about the auditor’s thoroughness and competence.

From Deloitte’s perspective, having a client restate earnings casts some doubt on the efficacy of one’s auditing, not to mention the slight embarrassment of having to make corrections to numbers that the firm’s own accountants blessed in prior years.  And how willing would Deloitte be to highlight its own past errors, which may have been pivotal?

Some of Mavin’s sources echo this concern:

    Nevertheless, the audit process at Nortel has “made a laughing stock of the [audit] industry,” said Anthony Scilipoti, executive vice-president at Veritas Investment Research. Mr. Scilipoti is also a chartered accountant and a member of a key accounting-issues committee at the Canadian Institute of Chartered Accountants.

    Nortel said the latest restatement is the result of a thorough review of sales contracts that showed the company was recording revenue in the wrong periods. The company will now be able to record higher revenue in future years.

    There have been no significant changes in accounting standards to force a change in policy. Some observers said yesterday the restatement shows either Deloitte and Nortel still haven’t got the numbers right despite all the hundreds of thousands of billable hours, or the auditors are not able to stand up to Nortel’s management on decisions about accounting treatments.

    “It brings the audit process itself into question, and that’s saddening for me. It’s the equivalent of a historian going back to re-write history,” he said.

    — Duncan Mavin, “How Nortel, auditor became joined at hip
Financial Post, 17 March 2006.  [emphasis mine]

Before I go much further, I should note that I am employed with one of Deloitte’s Big Four competitors, and I mean this as no slight against them or any of our competition — it is an unpleasant situation which any of the major accountancies could easily find themselves in.

A prime concern for the Big Four is that their auditors must always maintain a high degree of independence from the client.  Independence in this context meaning that the auditor is free of any authority, control or influence exercised by others — especially the client.  The auditors are required to maintain not just the fact of independence (such as refraining from personal investments in their firm’s audit or advisory clients), but also the appearance of it.  The dangers of lost independence are clear — witness the late Arthur Andersen firm.  When the public perceives you are no longer objective and trustworthy, your customer base evaporates.  And worse, if you have actually done wrong, forensic accounting will unquestionably bring the truth to light.

I don’t think Nortel or Deloitte have anything to hide, but I am perplexed that they can be so incredibly blind to the optics of the situation.  One party must surely recuse the other until the matter is settled equitably by a third party, and then confidence in all may be restored.  There’s more at stake here than mere dollars; there’s the reputation and future profitability of two large companies.  A proper audit must be done and also be seen to be done; neither firm is serving their own rational self-interest by pretending that this present course is wise.

UPDATE 202213Z MAR 2006: A slightly contrarian view from inside the industry, which I find myself in agreement with:

    Much of the debate around the world has been about auditor independence, including the contribution from professors Mano, Mouritsen, and Swearingen. Auditor independence is important, of course, but it is not all-important. Auditor independence is but a means to an end. The United Kingdom takes this issue seriously and has stringent measures in place, based on some very well understood principles. But what really matters is the quality of the audit, which, above all else, is itself dependent on the quality of the people who conduct it…

    It is worth remembering that most audit failures arise because of a failure by the auditor to understand the wider business dimensions, the areas of risk inherent in the business, or to see the big picture. Few if any audits fail because detailed procedures were not followed or because of a lack of independence. Thus, a broadly based business understanding is essential to good auditing. This will undoubtedly best be obtained in a multidisciplinary firm environment.

    The recent years’ scandals have, of course, undermined investor confidence. Because perception matters as much as reality, restoring that confidence requires not only that the right actions be taken, but also that the right actions are seen to have been taken. An improvement in perception, however, will be no more than a short-term victory if the reality is a fall in the quality of auditing. Instead, I would suggest that most of the steps necessary to restore confidence have already been taken.

    — Peter Wyman, “Is Auditor Independence Really the Solution?
The CPA Journal, April 2004.

None of which necessarily obviates the concern about Deloitte and Nortel.  On the contrary, one can easily surmise that the quality of the audit was less than stellar when a restatement of earnings is required.

Category: Finance, Industria
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