Video Posted: McKenna Speaks At AAA-Accounting Program Leaders Group Annual Meeting

Video of the speech including my ad-hoc remarks and the Q&A is here.

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I’m in San Diego at the Accounting Program Leaders Group/Federation of Schools of Accountancy annual seminar.

I spoke yesterday afternoon and the text of my remarks is below. I got a lot of questions afterward about the PCAOB Appendix I referred to. Here’s a direct link to that document. Go to the back of the document for the Appendix.

Here’s the text of my speech:

Thanks so much to Robert Ricketts, Frank Buckless and the program committee.

Before I begin, I want to mention I love to visit schools to talk with students and talk to faculty and PhD candidates about their research. Just ask Denise Smith from EIU or Frank Buckless from NC State about my visits there for an idea of the program. I’m a cheap date – a burger, a beer and a place to bunk is all I need.

Robert asked me to speak about the accounting profession and how it has performed in the period leading up to, during, and now after the financial crisis.

But before I do that, I want to share with you some of the feedback I get most often from accounting students and those at the beginning of their career. Since you are the team that prepares those professionals, I thought it might be interesting.

I’ve received a lot of comments, email, calls and letters in six plus years of writing the blog re: The Auditors, and now a few years writing for others like Forbes and American Banker and other publications.

Yes, I do get materials mailed to me in brown manila envelopes with strange postmarks and no return address.

There are almost 10,000 comments on my site and many of them were made when something happened like a layoff at one of the firms. Readers use the comments as a forum to share information as the situation develops. But many others are made about mundane, mercenary questions like recruiting, salaries, promotions and some of the scandals that have hit the firms themselves like the top level inside traders at EY and Deloitte.

The question I get most often from young professionals is: Which Big 4 firm is the best?

This question points to the high quality and high ambition of the graduates of your schools. They only want the best. Unfortunately, many of them also think their full potential as human beings can only be realized if they have a successful career in one of the Big 4 accounting firms.

If you promote that idea, you are setting them up for a fall.

We all know some transition success stories. Denny Beresford is retired senior leader of EY, now a PhD academic and esteemed board member as well as having led and served on standard setting and regulatory bodies. Scott Showalter, retired leader of KPMG and now an active academic at NC State and active thought leader for the profession on committees like PCAOB SAG. And now Tom Ray, alumni of two large firms and the AICPA, long-time public servant at the PCAOB, is an academic at Baruch.

But let me tell you about the phone calls I got in 2009-2010 when Deloitte started cutting partners. It was the wives that called or wrote. Their husbands were too embarrassed, shell shocked, bereft of a network and emotional resources to know what to do.

Peers had cut them off.  They had no job search skills.  They felt betrayed.  They had no way to evaluate their experience and skills and place them in the context of the business world in general, into a work environment that was different than they had experienced for the last 20-25 years.

Even worse were the young folks that were cut from all the firms before they had the typical 3-5 years of experience.  Some had less than two years on the job and hadn’t even passed the CPA exam yet.

Some may not have been, to borrow an unfortunate expression often used to assuage survivors’ guilt, “cut out” for a Big 4 audit firm life. It takes a certain interest and aptitude and it’s not “just a job,” especially when you audit public companies.

So please don’t push your students, or your own children, to choose the profession, or stay in it, for the money (?), fame (?), or easy life of the partner (??). None of those promises were ever entirely true and certainly they’re not true at all anymore because of demographics and the economic environment.  Make sure your students are committed to this vocation or let them take the opportunity, at a fairly early stage of their career, to choose a different path.

Please don’t train your graduates for a job. Please give them an education that will serve them for a lifetime.

Today’s accounting graduates think “best” can be quantified in terms of biggest firm by revenue or staff, most profitable (which you can’t know) some obvious measure of reputation like prestigious clients, highest salaries (not an issue since salaries are fixed via collusion between firms, Mercer, and the schools), shortest time to partner track (bad measure of quality but not a bad better measure of earning/career potential).

We all know, even if we won’t admit it publicly, that judgments of the firms are mostly subjective. There is good and bad at all of them, and advantages and disadvantages to each depending on the individual’s goals, objectives and personality. Your success is highly dependent on where and with whom you start your career. Pick a struggling office or a lousy practice partner and it doesn’t matter which firm you’re at – the first few years will be a huge challenge.

Individual assimilation and success in a Big 4 public accounting firm starts with selection based on university credentials, referrals from professors, family background, and business ties, as well as having political beliefs and economic philosophies that are aligned with firm values. This process now starts in some universities in freshman year, with some students having two or three internships before they graduate.

For some students it starts even earlier. One or both parents work for the audit firms or teach in accounting programs. Auditors often marry other auditors or accountants because in school or in their early career they have no time to date anyone else!

If your children are anything like you in talents and personality, it’s a natural. The career is one that has always been considered a safe choice.

My suggestion to students who ask me how to choose amongst the firms is to imagine eating pizza at midnight in a hot stuffy conference room during busy season with the group you meet on an office visit or during an internship. Are these the kinds of people I can work with under difficult circumstances, when I’m tired and frustrated?

The first few years set the course of the professional’s career. A good experience, good mentors, great learning experiences give your students the tools for life. Negative experiences mark them fast and mark them hard. It’s difficult to recover given the competition for the jobs.  Tell them to look at the partner and senior managers they meet and ask themselves if they are worth of their respect, can they learn from them.

Better yet, make sure your university’s program does not exclude the educational resources and the faculty support needed for students to consider jobs in industry, in the public and not-for-profit sectors, with smaller public accounting firms, and as academics as well. All are worthy uses of your students’ talents and deserve consideration. Programs should not be geared to only the top 10% graduates and to serving the Big 4 recruiting needs.  When you serve only that one master, I believe you abdicate a broader educational mission and your obligation to our profession to educate citizens and the professionals who may have to define career “success” in many different ways over the years.

Second question: Are auditors really supposed to find fraud?

This was the focus of my speech a few weeks ago to the AAA-Audit midyear conference in New Orleans. Many of you were there and heard my speech so I won’t repeat myself.  For those of you who weren’t there my remarks and slides are posted on my site and the AAA-Audit site. Suffice to say auditors do have obligations with regard to clients’ frauds and illegal acts. The PCAOB has produced the definitive guide, in my opinion, to what those are, step by step in the audit lifecycle from client acceptance and continuance to resignation and withdrawal of opinion. The PCAOB backs this up with the laws and standards that support those legal and regulatory requirements.

Case closed as far as I’m concerned.

More relevant questions for you as program leaders and accounting educators are: Why do our professionals commit fraud? Why aren’t CPAs whistleblowers? Why do auditors catch so few frauds?

Some accounting professors, no doubt, may blame themselves for allowing future fraudsters to graduate.

The Georgia Southern University Fraud and Forensic Accounting Education Conference is a good place to hear current thinking on these subjects. This conference, like so many on the forensic accounting circuit, often invites convicted felons – CPAs and other business professionals who became embezzlers, inside traders, etc. to talk about their experiences.

Here’s what I’ve heard:

1. It doesn’t matter what kind of background – good or bad – someone comes from. White-collar criminals have conservative, religious families, supportive, sacrificing parents and everything handed to them, too.
2. The often-referred-to Fraud Triangle is based on Donald Cressey’s work developed through interviews of embezzlers that were all male, over 40 years ago. Just look at some of the most most recent municipal frauds, like Rita Crundwell in Dixon Illinois, to see that even female accounts can be amoral. According to Cressey, the three elements necessary for heightened fraud risk are: pressure, opportunity, and rationalization. A fourth element, capability, has been suggested by Wolf and Hermanson. That makes it a Fraud Diamond.

Capability includes competence (recognizing and crafting the scheme). It also includes ego, social skills, and the belief that one will not get caught, but if one does, he or she will be able to talk his/her way out of it. Another paper worth reading is “Strain, Differential Association, and Coercion,” by Donegan and Gannon.

This paper talks about the impact of collusion and points to a ”bad crowd” mentality. Professor Diana Taylor at North Carolina State told me: “Cressey’s theory fits a single perpetrator with an unshareable financial need, working alone. Coercion theory explains financial statement fraud as strain placed on individuals to achieve material wealth, combined with differential association – getting in with a crowd that accepts fraud (i.e. HealthSouth family and Enron execs), which together coerce people into committing fraud – sometimes without their even being fully aware of the criminality of their actions.”

A recent Association of Certified Fraud Examiners study said accountants are among the 80% of professionals including procurement, human resources and sales that are most likely to commit fraud against their employers.  This speaks to opportunity and capability.

When I hear fraud stories that involve the auditors or company accountants, I think about this “coercion” factor. One thread seems to repeatedly emerge from the stories about accountants and auditors who are involved in frauds and illegal acts:

They’re all “pleasers”.

We all know accounting and audit professionals that are followers not leaders, total team players, the kind that bend over backward to please a boss. These are the students and young professionals who try over and over to please demanding parents, or girlfriends, boyfriends, or spouses with outward success and money. They have a hard time saying no to people, they don’t want to be left out, ostracized, or de-friended.

Some “pleasers” have troubled family backgrounds – alcoholic, abusive, mentally ill, or absent parent – regardless of socioeconomic background- that causes them to prioritize maintaining control over their life while avoiding conflict at all costs.

It may be good for business development for an auditor or a tax advisor to be a pleaser, but it’s bad when it comes to dealing with clients who lie, cheat or steal.

Warren Buffet, who many think is the greatest investor of all time, is a pleaser.  One of his biographers, Roger Lowenstein, described him this way when the Sokol scandal hit a couple of years ago.  You may recall Sokol, his heir apparent was caught looking out for his own interests rather than the company’s with regard to an acquisition.  Sokol was fired.

“Berkshire operates roughly 70 businesses, from energy to candy. Except for a few (such as insurance) in which Buffett has particular expertise, he leaves the details to his managers. He does not like to meddle or to be meddled with. Moreover, he is virtually allergic to confrontation. Plausibly, this is a result of his difficult childhood—of his unbalanced, disputative, and abusive mother, who would erupt, unpredictably, into vicious rages.

Whatever the origin, Buffett shrinks from personal confrontation and always has. Few capitalists have reached such heights with so little drama.”

My recommendation to educators who want to raise students who can resist the siren call of fraud is to keep an eye open for the “pleaser”.  That’s the relentless overachiever, the submissive follower, and the hero worshipper of a teacher or a prospective boss or firm. The person who avoids conflict and confrontation at all costs.

Professors can help students be more resilient by coaching independent critical thinking and the establishment of multiple career and life options.  Students need to control their own destiny, in spite of parents’ wishes, girlfriend or boyfriend issues, or the firm they choose.

Unfortunately, accounting and business professors may have many of the same personality characteristics as their students. Hopefully, they’ve gained the wisdom and emotional maturity that comes from age and experience.

A bigger obstacle to young professionals’ ability to control their own destinies is the conflicting goals of the accounting firms. The firms tell the universities they want recruits with critical thinking skills and independent spirits but that’s not what they hire. They hire “fit.”

If one or two free thinkers slip through, independent spirit is eventually crushed by the reality of what it takes to succeed in the Big 4 business.

Professors: Please teach your students about the principle of professional skepticism.

Students must never stop questioning authority.

People are like water – mutable. We’ll change from liquid to solid and back depending on the conditions. Few are immune to pressure, opportunity, and the potential for rationalization in extreme conditions.

Flexibility is a good quality. Resilience is better. Try to promote backbone instead a tendency to bend over backward to please.

Back to how we, as a profession, performed before, during, and after the financial crisis.

Two words. We sucked.

That’s not only me saying that. In March of 2011, the PCAOB’s Investor Advisory Group held their first meeting and the auditors’ role in the financial crisis was discussed. The recent financial crisis had presented auditors, and by extension the Sarbanes-Oxley Act reforms, with their first big test.

It was the conclusion of this working group that both auditors and the reforms under Sox had,  “by any objective measure”, failed that test.

Two years later, and five years since the financial firms started to fail, auditors are finally starting to answer for their role in crisis, albeit not exactly in all the cases you would expect.

Auditors have only sparingly been named as defendants in securities cases, including in the recent financial crisis lawsuits. According to a NERA Economic Consulting year-end report, only two federal securities class actions included an accounting firm codefendant in the initial complaint in 2012, about 1% of the total. Neither of these cases involved one of the big four accounting firms. Auditor liability cases are often filed in state courts, so this isn’t the whole picture but the trend is telling.

This is a big change compared to 2005-2009, when on average 6.9% of federal cases named accounting firm codefendants. In 2010-2011 about 3% of initial complaints named an accounting firm co-defendant. About 25% of filings included accounting allegations, down from 44% in 2008-2009 at the height of the wave of credit crisis litigation. That may explain the decline in firm co-defendants but does not explain why auditors are not named more often. That’s a story for another day, but I recently wrote an article for a client magazine put out by plaintiffs firm, Bernstein Litowitz Berger and Grossman, that talks about the legal impediments to auditor liability suits.  It’s in the winter 2013 issue. I will put a link on my site as soon as that article is available.

There are a few crisis era cases against auditors far enough along, though, to say auditors may be held accountable for fraud or negligence:

• There’s a trial scheduled to start in June this against Deloitte as auditor for Taylor Bean & Whitaker (TBW), a financial crisis era mortgage originator fraud where plaintiffs allege, based on the auditors reckless disregard for the standards, that there was “no audit at all”.

• PwC is the last defendant standing in a class action for the Colonial Bank failure, which is related to the Taylor Bean and Whitaker fraud. That case is pending a decision soon on PwC’s motion to dismiss. The FDIC recently sued PwC, and regional firm Crowe Horwath as the internal audit co-source vendor, for the Colonial Bank failure as well.

• In the class action case related to the Lehman failure, Ernst & Young is one of two remaining defendants. Barring a last minute settlement, we may finally see some of the facts of that case given a public airing at a trial. The New York Attorney General’s suit against EY is still pending and the SEC has not ruled out charges. However, the UK’s audit regulator, the Financial Reporting Council, has closed its case against EY over client funds segregation issues at Lehman.

But don’t get your hopes up. While federal and state securities fraud cases have recently been brought against auditors, such cases rarely, if ever, go to trial.  After Andersen’s high-profile demise, the Big Four global audit firms settle securities litigation before trial because they fear a judgment large enough to threaten their solvency and because they don’t want the public to see how the audit sausage is really made. Indeed, if there is substance to a claim, or negligence or complicity by an audit partner and his firm, the case usually settles before any facts are made public. The firms request the judge to seal any depositions or other preliminary documents. Judges usually agree based on the argument that the testimony will publicize proprietary methodologies or trade secrets.

KPMG audited Bank of America’s acquisition nightmare Countrywide and failed mortgage originator New Century Financial but settled those cases very early in the process. KPMG audits Citigroup (which ended up majority owned by the taxpayers), Standard Chartered, Deutsche Bank – recently subject of whistleblower claims about fair value accounting lapses, and HSBC, which has multiple recent illegal activity violations.

That’s just the banks.

Deloitte, I think, lost the most Fortune 100 audit business as a result the financial crisis. Bear Stearns, Washington Mutual, Fannie Mae, Taylor Bean & Whitaker, Merrill Lynch, American Home Mortgage, GM and Royal Bank of Scotland, are some of the major financial institutions and industrial companies audited by Deloitte that failed or were bailed out via forced acquisitions or nationalizations during the crisis.  But Deloitte also audits asset manager to the Fed BlackRock and publicly private equity firm Blackstone, two firms that have thrived as well as Morgan Stanley, which survived.

Royal Bank of Scotland just agreed to pay more than $600 million in fines for LIBOR rate manipulation and its Japanese subsidiary pled guilty to criminal charges in the case. Deloitte still audits Royal Bank of Scotland.

I recently wrote about PwC’s software integration partnership with audit client Thomson Reuters that I believe violates pre-Sox independence rules.

PwC also audits JP Morgan Chase, home of the “whale trade” fiasco.  Were those PwC auditors too stupid or complicit in allowing JPM’s Chief Investment Office to build up such a huge book of derivatives trades given such poor internal audit coverage, poor internal controls, confused risk and audit committee oversight and worthless fair value and valuation controls in that division? These weaknesses were cited by the banks own investigation and an OCC enforcement order.

Late last week, not one but two new reports of illegal acts at JP Morgan were alleged. There are allegations that JP Morgan, as well as Deloitte’s former clients Washington Mutual and Bear Stearns that were acquired by JPM during the credit crisis, flouted mortgage securitization quality controls and ignored problems, sometimes hiding them entirely, in the quest for higher profits. JPMorgan is also implicated in the Royal Bank of Scotland Libor rate fixing case. That’s because regulators contend JPMorgan coordinated its Swiss franc Libor submissions with RBS.

Barclays, another PwC audit client, was the first big bank to admit to LIBOR price fixing and paid a fine of more than a 450 million dollars.

The first person to ask a question after my keynote at the AAA-Audit Conference in New Orleans a few weeks ago set himself up as the devil’s advocate. He said my long list of audit failures, frauds, scandals and other illegal activities perpetrated by the firms and their clients just since the crisis might be considered “anecdotal evidence” and not conclusive proof that anything was really much worse or terribly wrong with the audit industry.

I refer you again to the PCAOB document on auditors’ obligations with regard to fraud and other illegal activities and leave you to decide for yourself, given the evidence, if the watchdogs have any teeth at all left.