Re:Balance -- Jim Peterson

Risk Assessment and Priority Setting -- When Word of Mouth is All the Recommendation You Need

Belated thanks for the interest and uptake on my post of June 20, on the dispiriting June 3 meeting of the US Treasury Department's Advisory Committee on the Auditing Profession -- here. I've fallen a little behind, having spent all last week working in Europe, where there are some very interesting developments involving the regulators. I'll be coming back to those, after a break for the Fourth of July.

Meanwhile, on a subject that lies behind my primary attention to financial and accountancy matters -- that is, the personal challenges to good risk assessment and priority setting -- I've been working to design a business school course on the tools and methods for choice-making, especially under the constraining limits on knowledge or resources.

A while ago I wrote about my skeptical attitude about casino gambling -- here. The related column below is from the International Herald Tribune of February 23, 2007. Reactions, and ideas for other teachable examples, are invited and welcome:

I recently needed help in choosing a good restaurant in New York. I am not current on the hot dining spots, so — as is typical in the process of daily decision-making — I had to sort and evaluate among competing alternative sources of advice.

The local version of the venerable Michelin red guide is struggling to establish itself in the Big Apple. Against it, the populist little purple Zagat Survey — born as a mimeographed collection of short-take amateur reviews by friends of the eponymous Tim and Nina Zagat — dominates the field.

Why is this? And what does the attempt to bring order among a multiplicity of influences have to say about priority-setting in a world of too much information and not enough certainty?

In one view, perhaps Michelin suffers from a Francophobic backlash against its expert-based star rating system and a century of make-or- break reputation effect in Europe.

Another view, just as likely, is that Zagat users take comfort in input based on common tastes and assumptions about price, quality or status. A Eurocentric critic of haute cuisine is assumed to have tastes that do not match ours. But if a broad sample of "people like us" finds a choice to be congenial, how wrong could we go?

Word-of-mouth has long shaped the successes of movies, music and fashion. Exploiting the principle, marketers in the world of electronic commerce are tracking the footprints of consumers. No sooner do you click-to-buy the Amazon book or the Orbitz vacation ticket than a pop-up appears: "Others who enjoyed your purchase have also bought all this other stuff."

Restaurants achieving favor with the Zagat reviewers tend to keep their high places on its popular list through a self-reinforcing circularity of fan support. Choices are validated by a vague and fuzzy sense of community that is both virtual and thoroughly artificial.

There are two related limitations on this consensus approach. The first, in the lingo of the game-theoreticians, is that of salience — the degree of importance, and especially the consequences, if the decision goes wrong. With standards that are subjective, the concept of a "good" dinner is elusive. But where the extent of commitment is limited to the price of a meal, the consequences are transitory and the downside is modest.

As a check on how much priority- setting can be done this way, think how tolerant we are of weather forecasters. They hang out their predictions every day, but they are never held accountable for the fickleness of actual outcomes. Because who really cares? For most of us, a surprise shower without an umbrella means at worst the discomfort of a change of wet clothes.

But for some people and in some cases, the degree of weather-prediction salience could be very high. Think of the impact on the launch of a space shuttle or the timing of a crop harvest or the order to evacuate before a coastal storm. When it is critical, decision makers will search well beyond the evening news or the farmers' almanac.

And that's the second limitation on consensus: when high-salience decisions demand high-level expertise.

Airline passengers may well consider each others' views about the choices of in-flight meals. But they are not invited to take a poll on the preferred way to fly the airplane. Likewise, hospital emergency room patients are not treated by popular vote, but under the leading judgment and expertise of the trauma surgeon. "Close enough" and "good value for the price" are not satisfactory performance standards for landing an Airbus or performing the Heimlich maneuver.

A hazard in daily life lies in sorting out what really matters from what doesn't. If a wardrobe advisor gets a style fad all wrong, the downside is an ill-considered garment that goes straight to the charity bin. But if an investment adviser gets a market trend or a sector swing all wrong, the downside could be a multi-decade asset impairment.

Taking a brother-in-law's hot tips on a wine choice can't cost very much, and might be good for family relations. Taking his hot tips in managing a retirement fund, on the other hand, could be hazardous to financial health.

External oversight can provide some help. We assume the competence of the airline pilot, without an interview about training and license; same for the bus driver and the pharmacist.

Still, as President Ronald Reagan advised when dealing with the Soviet Union on disarmament, "Trust — but verify." Which is why we'll compare among our friends' dining experiences, and why second opinions are commonplace in medical systems that are privately administered and insured.

Is there the same rigor in financial management decisions? A host of important choices might be candidates for second opinions: the size and structure of insurance programs, the details of estate plans, the percentage allocations among portfolio sectors, the deployment details within sectors.

The investment professionals do it, we know for sure. The awe-inspiring performance of the university endowment funds owes in good part to aggressive, hands-on maintenance of programs divided among advisers who compete for results and favor. How many of us are willing to do the same? It's a good guess that more energy goes into surveying our friends as to where to dine out.

Speaking of which, my hotel concierge in New York got me a table in an unreviewed little place down the street. I wouldn't have sought or taken his word on my retirement account. But acting on his advice and influence, I ate contentedly and well — which was all I could expect.

Catastrophe for the Audit Firms ... and the Talk Goes On, and On, and On ....

Did anyone really think that the endless chatter about saving the system of privately-provided audits for large global companies would come to anything?

If so, that fantasy was dispelled on June 3, in the closing minutes of the latest meeting of the U.S. Treasury’s Advisory Committee on the Auditing Profession – webcast here. In his summation, Co-Chairman Don Nicholaisen explicitly stated that, with an insubstantial exception, the Committee’s recommendations “do not address catastrophic risk” of the loss of the Big Four.

Why not? The Committee’s very mission is to “examine the sustainability of a strong and vibrant auditing profession” – here.

But if its members cannot face the potential for catastrophic failure of the Big Four, the Committee is serving no purpose. None of its other minutely examined but anodyne topics of inquiry – such as tweaking the standard for fraud detection or probing yet again the criteria for an accounting degree – will have any effect when another Big Four firm’s collapse takes down the entire business model.

Those durable enough for the entire webcast observed that the civility level of the dialog was frayed and degrading, even while the members spent the day largely talking past each other:

•    Testimony from the Big Four and the insurance industry provided the count of death-threat litigations: 27 cases with damage exposures above $1 billion, of which 7 exceeded $10 billion – with the estimated total between $100 and $140 billion. The large firms cling to their tactically sound but politically tone-deaf refusal to offer comprehensive data on their own financial condition, but the litigation potential to overwhelm their partners’ limited capital is unrebutted.

•    A committee member with a union background took the position that loss of another large accounting firm was an acceptable risk, asserting a risk comparison between an audit partner and a coal miner or a police officer. What he omitted was that while no single actor could threaten the entirety of the coal industry or the justice system, one more blown audit on the scale of an Enron or a WorldCom could end the deliverability of audits as known for 160 years.

•    Former SEC chief accountant and persistent critic of the profession, Lynn Turner, showed his hostility to the option of liability protection with the ring of a jury argument: “Do you believe that an auditor found to have been aware of financial reporting problems but never reporting them to the public should be the subject of liability caps or some type of litigation reform protecting them?” Yet Turner’s position that “this is about regulating a federally mandated and authorized cartel,” involving a “too big to fail” condition where market forces no longer work, is perilously close to a concession of how bleak the future is.

•    Committee member Gary Previts, historian of the profession and professor of accounting at Case Western University, put it in an academic’s genteel way: “I have often wondered if we aren’t trying to fix a business model … that is not subject to being fixed … if you started with a blank sheet of paper, whether we’d be organized the way we are today?”

The position that the Big Four must be left exposed to risks so dire that they could fail, clashes with the large firms’ showing of their inability to staunch the outflow of their limited resources in settlements of cases too large and dangerous to take to trial.

Further – so far as the availability of large company audits assumes the viability of the large audit firms themselves -- it is in conflict with the simultaneous view that the assurance function is so vital to investor interests that it must be preserved. Yet that is the very theme sounded in October 2007 by Treasury Secretary Hank Paulson in launching the Committee – that “a vibrant auditing profession is essential for a well-functioning financial reporting system (here).”   

So what is needed is a different cliché.

It’s not that the Big Four are “too big to fail.” Life is no safer for the survivors since the 2002 demise of the Andersen firm. They can fail. And the Committee’s co-chairman has now admitted that nothing is on the table to save them.

Rather, despite the lip service paid to the importance of audits to the capital markets, the regulators and politicians are themselves “too weak to stop failure.”

Put another way, those sincerely believing in the importance of large-company assurance are avoiding an election between two unappealing choices: Either put every effort to assure that the Big Four are insulated from the very catastrophic risks that the critics insist they must remain exposed to, or start the process of designing the new audit model that must arise after the collapse of the Big Four under the abdication of the Treasury Committee and its counterparts.

In the loud clanging of the Committee’s cognitive dissonance is the tolling of its usefulness. Chairman Nicholaisen’s concession of futility in the face of catastrophic risk says as much.

So the most the Committee can do is declare its one achievement – the comprehensive laying out of mutually-defeating antagonistic positions – and spare further contribution to the global level of greenhouse gasses.

Federal Charters for Accounting Firms -- A Blank Page Approach

Six years on from the disintegration of the Arthur Andersen firm, the fragility of the last Big Four and their franchise to provide large-company audits attracts a discussion that is steadily louder – but not more productive.

The latest example of a collection of the wise, talking past each other, was the June 3 meeting of the US Treasury’s Advisory Committee on the Audit Profession, summarized on Edith Orenstein’ blog – here – and webcast here.

A reason the discourse is so barren is the circularity of the blame-mongering. Rather than recognize the interlocking web of entanglements, the focus is on the problems of “the other guys.” The list includes:

•    Issuers’ incentives to manipulate their results
•    Overly complex accounting standards
•    Persistently inadequate audit performance by a too-small oligopoly
•    Regulators with over-lapping but parochial interests
•    Liability standards that lack precision in practice or predictability in outcomes, and
•    The overhang of catastrophe-level litigation that would overwhelm the audit firms’ fragile capital structures.

If there is ever to be a comprehensive, holistic solution, a blank-page approach is essential. There is such a framework at hand – although it would require a clean, robust and full-blown debate and a fresh legislative mandate. What is lacking, but essential in the organizational and legislative discussion, is the broad buy-in and ready participation that might actually replace today’s antagonistic finger-pointing.

Namely, national-level “charters” or “public company audit licenses” – the naming is less important than the concept – could authorize and regulate newly organized and re-structured firms -- that would do the audits of all public companies.

Applied in the United States – a jurisdiction necessary for any worldwide solution -- a new system would be administered by the Securities and Exchange Commission and the Public Company Accounting Oversight Board, having as analogies the government oversight of American stock exchanges, credit rating agencies and broker-dealers.

Newly organized “public company audit licensees” could be in corporate form. They could be owned by existing accounting networks or other new market entrants. Their resources – personnel, methodologies and technology – could be internal, or out-sourced from the existing Big Four or from emergent niche competitors.

For quality and enforcement purposes, audit engagement personnel would be individually licensed along with their employers, in coordination between federal authorities and existing state regulations over education, examination and training.  

Minimum capital requirements could be set, geared to the firms’ turnover or the capitalization of their client list. Governance structures could include independent outside directors, and accountability of management to agency oversight – measures not presently achievable under the constraints of state regulation and the laws of partnership and bankruptcy.

Collateral benefits to federal “chartering” abound:

Because these SEC licensees would be “audit only” enterprises, the multiple overlapping restrictions on scope of services would be finessed, and the endless debate over independence and permissible ancillary services could at last be ended.

Associated non-audit entities – whether parent or affiliate companies – would be freed from independence and compliance requirements, able to evolve beyond the one-page statutory report that now looks so obsolete. Targeted assurance reports could be designed that users in the capital markets would actually value and pay for. Immediate examples ripe for attention would have been Shell’s petroleum reserving, the internal trading controls regime at Société Générale, and the black hole of inter-company money transfers at Parmalat.

In aide of enhanced competition and expanded auditor choice, segments of the public company market could be specifically identified to encourage new entrants – such as high-risk or technically specialized sectors (IPO’s, troubled companies and financial services come to mind) – whose audits could be segregated, underwritten and priced as now done with high-risk insureds.

Under the aegis of the licensees’ regulators, a privileged forum could be organized to scrutinize cases of accounting and audit insufficiency for lessons and areas for improvement – drawing for experience on the airline, engineering and medical models for the successful study of failure.

As to liability -- the elephant in the room – and taking at their word the investor advocates who would prefer improved information over the capricious and low-return litigation lottery: the investigation and prosecution of all auditor claims based on public company financial statements would be pre-empted into the hands of the supervising agency. A specialized tribunal of expert jurists would hear all cases, levying fines and sanctions against convicted wrongdoers, both firms and individuals.

Compensation for legitimately damaged investors would be determined through the agency process rather than the caprice of juries and settlements, and be funded through a system of fee schedules rather than the hazards of limited firm capital.

Modifications of existing regimes would include elimination of the tax code’s incentives to maximize distribution of current revenues, and a cut-off above which audit firms would not audit their own owner/investors.

And with firewalls of corporate organization and bankruptcy infrastructure in place to limit liability, the conditions for insurability could be brought once more into alignment with manageable litigation and enforcement risk.

With this array of stabilizing governance changes in place, the new structures could at last be attractive to outside capital, which would be needed by offerors of new services in order to fund the necessary research, personnel and technology.

Given the dead-end nature of the debate these last years, the bare bones of this proposal should include something to excite or insult nearly everyone – which could be a signal that it is broad enough to be worthy of pursuit.