Re:Balance -- Jim Peterson

Auditor’s Report as Guaranty -- Is There Any Real Value There?

What value is delivered to investors and other users of financial information, in exchange for the fees paid to outside auditors? As today’s capital markets are evolving, can the assurance function of the large accounting firms survive survive the strains and retain any relevance?

The Law of Diminishing Returns

Originally published in the International Herald Tribune on December 2, 2006

The problem with children, the writer and social critic Fran Leibowitz has said, is that they are seldom in a position to lend you a truly interesting sum of money.

That, in fact, is the problem with a guaranty of any kind: It is worth no more than the resources standing behind it.

And, as is rapidly coming into focus for the world's large companies and their auditors, the problem with financial statement assurance is the fragility of the private accounting partnerships - whose resources, compared to the risks they undertake, are not material, much less truly interesting.

The dialog is developing on the need for corporate accounting and accountability to evolve well beyond backward-looking and useless quarterly and annual reports. The latest entry in the debate came from the U.S. Treasury secretary, Henry Paulson Jr., who, in a speech in New York on Nov. 20 (here) , offered none-too- subtle praise for Britain's "light-touch" approach to auditing standards and regulation, even while observing that the reduction of the large-company audit market to the surviving Big Four firms "may not be healthy."

In this great game, the accountants naturally see themselves as central players. But the imperiled state of the Big Four and their highly concentrated audit franchise is a problem of nontrivial proportion. And Paulson's question - "Is there enough competition?" - sidesteps a crucial issue: Do the Big Four have the wherewithal to stay in the game at all?

A comparison of the accountants' resources to the ostensible value of their opinions is one way to assess the basic question of who can and should provide the assurance of the future.

The value of reliance is capped by limits on a guarantor's resources. In the entire credit industry, exposures are linked to ability to pay: the maximum size of a home mortgage is measured by the collateral value of the house; credit card ceilings are tied to payment history; even casino markers are designed to be collected, by means legitimate or not.

The ability to deliver against expectations is questioned everywhere. Bail bonds require sureties. Stock traders have strict collars on their portfolio exposures. Insurance policies are written with defined risks and fixed limits.
Think beyond the business world. An athlete's pre-game swagger is immediately tested by the scoreboard. The power and protection of multinational diplomacy depend on the strength of the available military and economic forces. For proof, consider this: Nobody seeks a mutual defense pact or a trading partnership with Zimbabwe.
In London, a banker may say with some credibility that "my word is my bond," but as the movie mogul Sam Goldwyn also put it, "An oral contract isn't worth the paper it's printed on." Both, sadly, are true.

So what is an audit report really worth to global companies whose individual market capitalizations dwarf the resources of the auditors?

The revenues of the largest 25 companies in the Fortune 500 ranged last year from $55 billion for Dell to $370 billion at Exxon Mobil. A recent study now in the hands of the European internal markets and services commissioner, Charlie McGreevy (here) , estimates that the liability "tipping point" that would take down a Big Four firm in Britain ranges from €170 million, or $223 million, to €540 million - amounts that hardly register against either the size of the companies they audit or the damages that can arise from large claims overhanging the firms themselves.

Those modest amounts effectively limit the amount of "audit insurance" that a large company purchases to be in compliance with the securities regulations requiring statutory audits.

Given all this, wouldn't it be rational - not to say normal - for a finance director or chief information officer to think this way:

"What are we getting in exchange for our audit fee? A report that nobody reads or values, and insignificant protection in the event we suffer a large-scale financial or audit problem.
"Wouldn't it make more sense to ask our own people for assurance on the quality and integrity of our systems and reporting? They design, own and operate the systems, so they are the most informed and best positioned - unlike the auditors who perform only a sampling function anyway, and who are constrained by obsolete requirements of independence from immersing themselves deeply in those very systems.
"If only the regulators didn't require us to commission and pay for these low-limit, effectively worthless reports, couldn't we hire our accounting firms to design and perform work that both we and our investors and bankers would really value?"

Don't hold your breath.

No chief executive of a Big Four accounting firm could face his partners by admitting the acuity of those messages, and they lack the support in the capital markets to seize the initiative and re-design their business models.

But on their behalf, there is a clear message for regulators in Washington and Brussels and London. In a world of globalized capital flows, ready to migrate away from regulatory excess, it would be this business ultimatum:

Because the best a company can expect in a financial statement disaster is less than $1 billion of auditor support, the current system is not working. Unless it is fundamentally redesigned, the large companies will shortly declare it irrelevant and opt out.

On these issues, even Leibowitz would have echoed Groucho Marx: "A child of 5 would understand this. Send someone to fetch a child of 5."

Outside Investors: No Fix for the Large Accounting Firms

What Money Can't Fix

Originally published in the International Herald Tribune on April 6, 2007

Billy Rose, the legendary Broadway producer of the 1920s and 1930s, offered a maxim to anyone hoping to replicate his success: "Never invest your money in anything that eats." Rose was referring to showgirls and racehorses, but his admonition could apply equally to accountants and auditors.

In a report released in mid-March(here), the U.S. Chamber of Commerce, a trade group and lobbyist for American business, advanced the notion that client service by the four remaining global accounting partnerships would be better provided if the accounting firms could bring in outside investors, like private equity or venture capitalists.

The global firms, not so long ago numbering eight, are stretched to their limits by the corporate governance requirements of the American Sarbanes-Oxley law and threatened with multibillion-dollar litigation liability. Cash infusions, the chamber argues, would either support survival-level insurability, or encourage the creation of new firms to lighten the load of and provide competition to the current Big Four.

The business group's report - the latest of a growing body of commentary bemoaning the erosion of American competitiveness in world capital markets - makes some good points. It calls for cooperation among domestic and international policy makers, and it suggests that U.S.-based auditors of public companies might better operate and be regulated under national government charter, supplanting the current patchwork of state-level authority.

But on the issue of outside capital, for several reasons, the report is wrong. It is not a solution.

For starters, what would be the real role of venture funding or private equity in a global accounting partnership? The business model is that the firms are capitalized by their partners' collective contribution, and the partners share in the profits. But the Big Four firms already manage to run their global operations today on the modest working capital provided by their individual partners. Simply put, they don't need the money.

And since no capital comes cost-free, the accounting partners would have to vote away major portions of their current personal profits to pay the handsome return on investment that private equity investors would demand.

If the idea is that fattening the firms' balance sheets would cushion a huge litigation charge, then it's doubly perverse. If increased capital acts as a form of self-insurance, a simpler solution is immediately available: New insurance companies might provide the Big Four with the high-limit coverage that is not available today.

The trouble is, the business case goes the other way: Billion-dollar coverage is not to be had at any price. Rational insurance industry decision makers see the accountants as effectively noninsurable at levels meaningful to their survival.

And for the other perversity, exposing any additional capital to the hazard of plaintiffs' claims would only feed the beast of litigation. It's basic economics: Prices rise to eat up available subsidies. If dog food costs $1 a can, and for public policy reasons a subsidy of $1 is made available, the consumers' cost immediately becomes $2.

The same goes for litigation settlements. Arthur Andersen's defunct U.S. unit has just settled its Enron litigation for $72.5 million - the most the plaintiffs could get out of the dry husk of this once-great enterprise. But in 2002, plaintiffs hailed Enron as the first billion-dollar settlement payment from an audit firm - an outcome frustrated only by the death of the Andersen global partnership, the golden goose that laid those eggs.

The chamber's other argument in favor of outside capital is to finance new competitors to the Big Four. But studies last autumn by two consultancies, London Economics and Oxera (here) , concluded that creation of a Big Fifth or Sixth would require talent, funds and risk appetites that simply do not exist. Shrinkage to the critically small quartet has followed a natural, inevitable and irreversible evolutionary course. There is neither incentive nor authority to expand among the Big Four, their smaller brethren or the clients - and certainly not with regulators.

Finally, despite Billy Rose's caution, venturesome capital has an insatiable and nearly unreasoning appetite, with an urge to engulf and devour that now runs from the Four Seasons hotels to Boots pharmacies to Madame Tussaud's wax museums. If the private equity funds saw a compelling case to invest with the accountants, they would already be there.

In short, pumping outsiders' funds into the accounting firms is a solution nobody wants, for a problem that their money cannot solve. The suggestion is not a silver bullet, but a popgun blank.

The Accountants' Own Search to Establish Real Value

Accountants and Auditors: Time to Part Company?

Originally published in the International Herald Tribune on November 18, 2006

"Sell when you can. You are not for all markets." --
    Rosalind to Phebe, "As You Like It," Act III, Scene V

In advising a country girl to accept her suitor's offer, Shakespeare had it right: Seizing the opportunity to adapt a narrowly focused product or service to changed conditions is a challenge.

Especially these days for the global accounting firms. Last week the six largest global networks - the Big Four of Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers, joined by Grant Thornton and BDO - issued a joint report that finally brought into the open a theme long recognized but little discussed: the uselessness of the current financial reporting model.

As laid out in the report - snappily titled "Global Capital Markets and the Global Economy" and available here -- the traditional backward- looking "snapshot" of a quarterly or annual report is obsolete and requires replacement. It vaults into the 21st Century by proposing, among other things, an Internet-based system in which extracts of corporate information are delivered to users on a customized, real-time basis.

This evolution in information reporting is probably inevitable. But whether the large accounting firms can achieve their aspirations - either to lead the dialog or to provide whatever assurance the new world may want - is another matter that faces several hurdles.

The first is the prospect of the large firms obtaining the relief they seek from life-threatening litigation risks. That prospect was never likely under the profession's post-Enron scrutiny, and became even less so with the last U.S. elections, that delivered both houses of the legislature into the control of the plaintiff-friendly Democrats.

The large accounting firms are also floating the trial balloon of selling special "forensic audits" - investigations of an enforcement-type character, to be done at random or even on a regular schedule. The greater user cost would in theory be offset by a higher likelihood of fraud detection.

Which brings us to the second hurdle: The market's understandable skepticism. If the auditors really knew how to detect fraud more effectively, why for their own survival's sake would they not be doing that work already?

Finally, an unexplored issue in the failure of the profession to move public perception lurks in their very identity: "accountants and auditors."

No other profession needs two words to name itself. Think of about it: Doctor. Lawyer. Engineer. Priest. Soldier.
Right beneath the surface of the nomenclature lies the unreconciled duality of the competing functions. Put simply, while accountants are at least tolerated if not always welcomed in the corridors of commerce, nobody really wants an auditor around.

Accounting functions have been essential since the first trade routes opened along the Mediterranean coastline. As soon as contracts spanned time periods, transferred risk among parties, or crossed currencies, someone had to set and apply the rules and conventions for their recording and valuation. From the simplest issues of bad debt reserves to the most exotic design of complex off- balance sheet financial derivatives, the expertise of the accountants has been needed for the sake of trade.

But nobody ever welcomes the auditors - the snoopy little creeps. If the financial reporting system were put in medical or health care terms, the auditors would be the proctologists: intrusive, probing around in the dark, leaving a client feeling uncomfortable and invaded, and unable to promise that the next year's exam might not reveal a rapidly growing malignity.

As for the lack of value in the core product, the auditor's report, it has been decades since a candid banker or sophisticated investor would admit to actually reading one. If it weren't for the outmoded requirements of the securities regulators, no chief financial officer would ever pay for one.

The duality could be resolved, although compliance and regulatory regimes would be subject to fundamental change.

Here's how: The audit function could be spun off by the large firms to newly formed specialist units - perhaps linked with their global structures or freestanding - or even to the governments themselves.

With such a restructuring, the capital markets would quickly establish whether the compliance-driven output had any user value other than zero.

Freed of both the liability burden of statutory compliance and the deadening hand of out-of-date regulation, the large accounting firms would then finally have the room and freedom to invent and market new forms of both reporting and assurance, for which users would be happy to pay.

They would have to compete with the niche consultancies already working to fill the space. But they would at last be able to offer reports tailored by geography, industry, product line or materiality - all matters presently outside the limits of their liability- constrained sphere.

The prospects of change are dire, of course.

Although the large firms' recent paper is so bold, or so feckless, as actually to presume that liability reform will occur, the poor accountants are essentially friendless. Even purveyors of misery like the tobacco companies and the handgun manufacturers can buy both influence and affection in the legislative chambers. But the poverty of the accountants' message is all the more stark for their failure to attract support, much less friendship, to their cause.

For their future's sake, however, they had better improve the selling of their message. The recent report may be their last chance to make a start.