Accounting Is the Next Virtual Profession

Posted by jmalone on July 22, 2010

Consider the following:

• nearly all accountants are introverts, and introverts like sitting in the back office typing at their keyboards (once called ‘paperwork’).
• introverts are the backbone of accounting and management information systems, since ‘someone’ has to do it.
• ‘best practices’ company information systems allow any crucial report or document to be available by any authorized person anywhere anytime.
• technology has enabled both the task and the result to be possible anywhere there is a broadband connection.
• today’s young people define ‘work – life balance’ as more the ability to choose ‘where’ and ‘when’ instead of ‘how much’ work is to be done.  Young people in this country are not afraid of hard work.  Technology allows those ‘where’ and ‘when’ choices and they are demanding such.
• such paperless systems are already in operation in all the world’s largest companies because they have to be to function 24 hours a day across the globe.
• smaller companies are seeing more of the advantages of the above, and younger managers are more willing each year to convert.

The above lead to one conclusion:  accounting will be the next Virtual Profession.

 As I get older, I can dig it.

Fraud in Microcap Stocks

Posted by jmalone on

I wish I could publish statistics.  I wish I could cite numbers, because everyone knows that numbers don’t lie.  But I cannot find any – I can only cite anecdotal evidence.

Some regulators and many large accounting and law firms swear that ‘most stock market fraud lies with microcaps’ and ‘microcap fraud is about financial statement errors.’

I believe both of these statements are false.  Here is my evidence:

 1. Our firm does a lot of microcap auditing.  We audit more microcaps than any other firm.  During the last 7 years, our firm’s audit workpapers have been subpoenaed about 8 times in fraud investigations.  On 2 such occasions, one of our partners had to give formal testimony to SEC Enforcement Division.  To our knowledge, none of these 8 times had any financial statement fraud allegations or facts.  Every one of them was about stock manipulation – popularly called ‘pump and dump.’

2. Auditors and their regulators both rely heavily on ‘materiality’ as a practice and enforcement standard.  The world of accounting is a world of estimates.  All companies have errors occurring in their books regularly, with the vast majority being both small and unintentional.  In many microcap companies, the entire financial statements are immaterial, because the qualitative definition of ‘material’ is whether an investor would consider the matter important enough to impact his decision to buy or sell that company’s stock.  For most microcaps, major changes in the financials would make zero difference.  Let’s talk ‘typical’ changes, such as a different valuation of stock issued for services, or a derivative resulting from renegotiation of unpaid debt.  Investors don’t buy microcap stocks because of their financial trends, they buy because they believe the idea has merit.

3. I personally know a number of fellow practitioners and I myself have been auditing small public companies for 15 years.  My statements above appear to be in consensus with those of my small firm peers.

4. Bernie Madoff and Alan Stanford would both be classified as ‘large’ company frauds, since each stole billions.  How many microcap ‘pump and dump’ schemes would it take to add up to this much theft?

5. I concede that there are more small company frauds than large company frauds.  However, it takes a very large number of small company frauds to offset an Enron or a Worldcom or a Madoff.  I don’t think there are nearly that many, never mind adding all the other large company frauds.  It is the size of the fraud that counts, not the sheer number.

To those regulators and big firm pundits that agree with the above, I thank you and am grateful.  I just cannot empirically prove my position.

Microcap Audit Marketplace Trends

Posted by jmalone on

The Sarbanes-Oxley Act of 2002 substantially changed how auditing and financial reporting has changed for microcap companies (aka ‘non-accelerated filers’).  The new PCAOB and increased SEC budget have enabled thousands of new accountant bureaucrats to create ever-higher standards for auditing and reporting.  ‘One Size Fits All’ remains the SEC mantra from decades ago.  But the informal SEC ‘don’t ask, don’t tell’ standards flexibility for small companies in previous times was stamped out with this regulatory sea-change which began in 2003.

Notable changes in the past 2 years include:

• much higher auditing budgets, because higher standards take more time and more expertise.  Not even counting internal controls auditing, which has never been applied to non-accelerated filers, audit fees almost doubled 2004 – 2007 vs. 2000 – 2003.  However, with the recession and greater numbers of firms competing, fees are shrinking back.  I estimate fees are now only 20% higher than pre-Sarbox.
• a handful of small firms have denied licenses by PCAOB. I count 8.
• another group of small firms have ceased their SEC practices because of a decision probably influenced by this more-competitive and harsher regulatory environment.  I count 17.
• hundreds of new firms become ‘PCAOB-registered’ each year, and only a handful actually acquire any SEC audit clients.  These newcomers more than replace the few who have left the business, so the lure of economic opportunity still outweighs the risks as perceived.
• a large number of Top 100 firms continue to carefully groom their SEC client base, weeding out any suspected of inadequate competency and integrity.  1/3 of Top 100 firms don’t have an SEC practice and another 1/3 have only a token (< $2 million in annual fees) SEC practice.  This kind of work definitely isn’t for everyone.
• Only 3 Top 100 firms seem receptive to auditing microcaps, and all 3 are in New York City.
• a large number of micro- and mid-cap operating companies have gone out of business, gone private or merged and have not been replaced by new ones.  The number of non-operating ‘shell’ and development stage companies has grown from about 1,000 to almost 3,000 today.  The total number of public companies (excluding funds and trusts) has declined from about 10,000 to about 8,500 or so.
• auditing and financial reporting quality have both grown substantially.  The regulators should take a very large share of this credit.  Also worthy of mention is the increased use of paperless methodology and auditing software which forces us to audit and document the same way.  Technology has been a boon to accountants everywhere.  Standards have never been so uniformly applied.
• the recent ‘bank credit crunch’ has hurt the marketplace severely.  Activity is way down and won’t resume former volumes until this is sorted out.
• competitive fee pressure has allowed or enabled a few more mid-sized public companies to choose smaller accounting firms.  Most mid-cap choices are limited by litigation-conscious boards who still insist on the largest accounting firm who will return their phone call.

Summary of findings:

•  small public companies will continue to proliferate, although in smaller numbers – the going will remain hard until the credit crunch is resolved
• a never-ending supply of new accounting firms to the marketplace will keep fees low and regulatory police actions frequent 

Ah, capitalism.  It prospers, in spite of heavy regulatory supervision.

Alert! Foreign Auditors Thumb Noses at PCAOB!

Posted by jmalone on July 19, 2010

Earlier this year and through certain country diplomatic channels, the PCAOB was notified that foreign accountants who audit companies which list their shares on U.S. capital markets will not allow the PCAOB to inspect their audit workpaper documentation.  Concurrently, the PCAOB has had other issues on its front burner such as defending its very existence in the court system and the fact that its 5-member board has 1 formal vacancy and 2 additional board members whose terms have expired.  Now that their recent Supreme Court existential threat distraction is gone, I believe the PCAOB will proceed with adding the 3 new directors and ‘then’ they’ll consider more options.  I speculate they will tackle this threat next year after their board is full strength again.

Meanwhile, the PCAOB and SEC each have recently issued warning memos:

• SEC’s warning said that U.S. parent accounting firms will be held responsible for the quality of their foreign branches.  Since almost all foreign firms with similar names to U.S. firms are separate legal entities, this threat will only extend where the investing public has reason to believe that the U.S. entity has accepted significant responsibility for financial statement audits.  That means ‘near zero.’
• The PCAOB’s warning said that U.S. accounting firms that audit foreign subsidiaries or divisions and use foreign-located auditors must adhere to specific standards in supervising them, including substantial physical presence and  foreign language capabilities.  Apparently, a number of our smaller competitors have subcontracted out entire audits or large portions thereof to foreign contractors or foreign firms for such foreign company auditors.

Both warnings are aimed at the Chinese market, which has ballooned in the last 5 years.  The PCAOB has defined the standards threat, which has 2 threads:

• U.S. firms subcontracting work and not supervising it thoroughly, leading to audit reports not backed up by expected quality, and
•  Foreign firms that issue independent audit reports that shortcut U.S. auditing standards.

The PCAOB and SEC have the tools to adequately deal with the first problem because they can pull those firms’ licenses to audit public companies, even though they have been slow to implement needed changes.

For the second problem, if the PCAOB cannot supervise foreign firms, will U.S. investors continue to accept their reports?  The capital markets will make that decision, and I’ll bet they’ll move more quickly, now that the problem is made public.  Maybe the capital markets can adequately regulate this issue themselves – what a concept!  I’ll keep you posted on this outcome.

US Auditing Standards (GAAS) vs International Standards (IAS)

Posted by admin on

U.S. auditing rules are very, very different from international standards, and these differences increased substantially with the passage of the Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board (PCAOB) which regulates the auditing practices for all U.S. public companies.  Most of the rest of the world uses standards which are mainly designed as a tax compliance measure – in many foreign countries, independent accountants must prepare every company’s income tax return and they must use limited and codified auditing procedures in their review of each company’s books before preparing the returns.  Foreign auditors use much the same procedures when auditing public companies, and these standards are significantly lighter than U.S. standards.

U.S. literature and news stories have avoided discussing these differences, which are far bigger than any differences in financial reporting standards  — see my blog #1 – US Accounting Principles (GAAP) vs. International Principles (IFRS).

I know of no ‘auditing standards convergence’ effort to lessen these differences, but I do know that auditors cannot perform both well in their jobs – they must train for and practice only one.  Significant differences also exist between U.S. private company vs. public company standards.  The American Institute of Certified Public Accountants (AICPA) supervises private standards and PCAOB supervises public standards.  The written letter of the standards is 99.9% the same, but how they are enforced are very, very different, leading to two different mindsets.  U.S. national accounting firms teach their staff only the public standard, whether for public or private companies.  Smaller accounting firms use the admittedly lesser private standard.  Trouble is occurring where the smaller accounting firms use the private standard on public companies, which PCAOB is trying to eradicate.

As I’ve previously said, ‘it is all about the money.’  Foreign societies consciously choose not to spend as much on their accounting profession as we do, so foreign auditors are not being paid to adopt our higher standards.  We say that our financial markets have more quality because our auditing standards are higher.  But our higher public company standards clash with our more economical private company standards – which will prevail in the U.S?

US Accounting Principles (GAAP) vs. International Principles (IFRS)

Posted by admin on July 18, 2010

U.S. accounting rules are known as GAAP.  International Financial Reporting Standards are promulgated almost everywhere else in the world.  A bi-partisan committee of accountants is trying to make the two identical in accounting treatment for all significant areas, a process known as ‘convergence.’  However, the major difference is U.S. standards are ‘rules-based’ with a few thousand pages of detailed rules to follow, while international standards are ‘principles-based’ with far fewer specific rules.  The rest of the world is putting pressure on the U.S. to adopt a ‘principles-based’ approach. 

The U.S. Securities and Exchange Commission has been studying IFRS for years and has privately concluded that they have 2 major problems to adopting IFRS:  (a) a rules-based approach is far easier to enforce because rules are bright-line tests – you either follow them or you don’t, and (b) European governments have made it clear that the international standards-setting body which administers IFRS is subject to their authority, meaning politics can override the accounting profession.  I speculate that SEC believes both are insurmountable problems and that we’ll never adopt IFRS until major changes occur on both issues.

Convergence won’t solve either problem, but it will bring together how various transactions are accounted for in general.  It will proceed regardless of the greater 2 problems presented.

The pressure for the U.S. to adopt IFRS is from the biggest accounting firms which want the opportunities to make more money and have more influence in accounting policies and procedures.  A rules-based enforcement regime is a more ‘level playing field’ where all of us know the certainty and outcome and the larger firms don’t have an edge in promulgating or interpreting.

Our American society values our accountants’ expertise more than the rest of the world does, and our accounting profession is trusted more to be the gatekeepers to our society’s financial reporting system, which remains the best in the world.  ‘It is all about the money,’ and when the rest of the world’s accountants are paid more, they’ll step up to our standards.