Re:Balance -- Jim Peterson

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.

Ernst & Young Consolidates -- And History Asks: Who Cares?

This one comes straight from the heart.

First, I salute the plan announced in early May by Ernst & Young, to merge its practices in 87 countries in Europe, the Middle East, India and Africa. Sharing of management, strategy and costs will create the most integrated accountancy structure since the disintegration of Arthur Andersen in 2002.

It’s a bold move, in a terrifying environment, both worthy and full of challenges to execute and deliver.

But, to say with reluctance, it compares with the poor cabin boys re-arranging the deck chairs on the Titanic.

I was first an outside counsel, and later an employee, of the late Andersen firm. I was then privileged to be one of its worldwide partners – and personally fortunate to have retired before the wrenching events of its failure.

So the discouraging phrase – “been there, done that” – hangs over E&Y’s initiative. Its necessary evolution will address the complex demands for quality services to global companies. But that is insufficient – nay, irrelevant – to shorten the list of life-threatening issues facing the Big Four.

E&Y is not operating in virgin territory. Andersen’s worldwide partners shared both economic risks and benefits. We supported start-up practices in new countries, and lagging economies in others. And we reaped unequalled revenue and profitability from the effective deployment of shared technologies, methodologies and personnel.

But while Andersen’s unique cohesiveness drove an almighty profit machine in times of prosperity, it proved weak and fragile under stress – shattering into local fragments within days of the US firm’s Enron-related criminal indictment.

Unifying E&Y’s practices will be a big deal for its partners – but much less important to its employees – and a matter of indifference to issuers and the consumers of its audit reports. As an inward-facing matter of management strategy, it does not change the commodity nature of the standard audit report, whose value in the capital markets is so diminished as to be serving no purpose beyond regulatory compliance.

The report is instead an unevolved and obsolete barrier to the required re-engineering of the corporate financial reporting model, and a litigation ticket to oblivion as much for a re-designed E&Y as for the other firms.

E&Y’s consolidation may have a quality impact on its cross-border work. All concerned should hope so. But just as Parmalat in Italy and Lernout & Hauspie in Korea showed that major litigation inheres in cross-border work, there is also deadly peril from purely local jobs – examples run from the Houston-based impact of Enron on Andersen to the pending exposure of BDO International to litigation damages for the Miami work of Seidman, its US firm (here).

Giving E&Y the benefit of the doubt, a single regional partnership may – with massive investment of resources and personnel – mitigate its cross-border divisions. These are driven by differences in culture, language, corporate governance, professional standards and education. But those issues deeply persisted in Andersen’s regional operations, despite decades of effort -- making E&Y’s reprise an incremental step at best.       

At the same time, as Andersen showed, a unified structure that suffers a knockout blow in a critical country does not survive. And it need not be an American issue.

A look at France is instructive. The latest report from its market regulator on auditor/client relations among the CAC 40 – here -- shows the depth of E&Y’s blue-chip client list: of the 37 companies for which data are available, E&Y is principal or secondary auditor of 22.

Included are global companies that are hardly risk-free – among those with media notoriety are EADS, Société Générale and Vivendi. Any on E&Y’s global roster could inflict on its French practice a blow that would be fatal to its EMEIA structure. For in a globalized world, a firm that cannot practice in all economies on the scale of the G-8 countries cannot viably provide comprehensive service to large companies in any of them.

All these examples show that mega-threat litigation remains the uninvited elephant crashing E&Y’s party. EMEIA and Far East mergers may not actually raise the EY network’s collective exposure – firewalls and careful agreements may have some slight effect.

But again, the Andersen experience shows the irrelevance of structure to the outside world. Quality issues and the assertion of cross-border jurisdiction both track the actual performance of cross-border, risk-laden audit work. And it makes not a bit of difference to investors’ lawyers whether multi-country engagement teams are led by fellow partners or franchisees using only a common name.

The partners of Arthur Andersen, who designed and ran its unified global practice, banked their fortunes under the impression that they were riding a gravy train, resistant to external shocks or self-inflicted mis-management.

The history of their downfall suggests that while we should wish the best for the vision of E&Y’s leaders, the warning lights on its track to the future are blinking brightly.

The Future of Auditors as Gate-Keepers -- A Glossary of The Non-Solutions

Do investors get real value from their gate-keepers? It was a main question at a conference of international investment managers where I spoke last week.

This group -- who sit over funds across the spectrum from public employee and union pensions to hedge funds and private equity – had common concerns: corporate governance, ethics, compensation and performance, and the quality and reliability of the third-parties – the analysts, rating agencies and outside auditors.

On the subject of the auditors, I had a brief opportunity to offer this three-fold view – familiar enough to regular readers here, but beyond orthodoxy to many in the audience (and with thanks to Mark Cobley at Financial News Online for the uptake):

•    That the traditional form of auditor’s report is obsolete and provides no investor value, especially compared to the possible forms of assurance that are impossible under the current model -- here;

•    That the overwhelming pressures on the Big Four firms render their current business model unsustainable, and their litigation-based exposure makes disintegration inevitable, absent a radical and comprehensive re-engineering – here;

•    That the current dialog on achievable solutions is vapid and sterile, due to denial, blame-shifting and the limited vision of all of the interested constituencies -- here and here.

In the ensuing barrage of panelists’ skepticism, audience questions and post-session follow-up, I was challenged to answer in single sentences to all the standard one-dimensional “solutions” to the fragility of the current Big Four structure.

Bringing those exchanges together here, with links to their more extensive treatment elsewhere, seems worthwhile – even if only in sound-bite form: 

•    Q: Why isn’t the litigation threat to the Big Four well handled by insurance?

A: Having learned from the savings & loans in the 1980’s the expensive lesson that auditor liability fails the basic criteria for insurability – diversification, predictability and quantification – the insurance industry has voted with its feet -- here.  

•    Q: If lack of auditor choice is the issue, how about creating competitors by splitting up the Big Four?

A: For starters there’s no workable legal theory. Either industry and geographic expertise would stay concentrated, in which case nothing is achieved, or they would be so split up that today’s talent level would be severely diluted.

•    Q: Can’t the issue of Big Four concentration be solved by built-up competition from the smaller firms?

A: The size gap is just too large to bridge – see here – and the smaller firms are if anything even more at litigation risk – see here. Anyway, smart risk managers in those firms would avoid global-scale engagements for which they lack either the skills or the risk appetite.

•    Q: If the rules on audit firm ownership were relaxed, wouldn’t outside capital both strengthen the Big Four firms and support new competitors?

A: The Big Four don’t want or need extra capital to run as they do – here. And the bankers have shown they are smart enough not to sacrifice new money that would only fuel the litigation fires.

•    Q: How about improving audit quality by requiring the rotation of auditors?

A: Italy being the only large country to mandate changes in auditors, experience provides a one-word rebuttal: “Parmalat.”

•    Q: Doesn’t a system of joint or dual audit promote higher quality of performance?

A: Proponents in France, which has almost no history of auditor liability litigation, would quickly change their tune when joint auditors became subject to 100% joint and several liability in the courts of other countries.

•    Q: Isn’t the problem of impaired audit independence the fact that it’s the clients who pay the bills?

A: Consider the alternative: funding audits through an agency or regulator amounts to nationalization – and no one makes the case for audits by government civil servants. 

•    Q: How about caps on litigation liability – either money limits or percentage allocation of fault?

A: Because the size of claims arising out of large corporate failures so completely dwarfs the limited financial capability of the Big Four – here – the political process cannot set a survival bar so low as to ensure the stability of a large firm under serious litigation threat.  

•    Q: Wouldn’t performance standards based on principles rather than rules recognize the judgmental nature of auditing?

A: Standard-setters cannot reduce the liability threat, so long as it is courts and juries who assess auditor fault and liability, unless there is the readiness – so far unseen – to enact “safe harbors” to protect the auditors’ judgments.  

•    Q: If another Big Four firm were failing, couldn’t regulators waive the scope of service limitations so that another firm could step in?

A: Even if the large firms weren’t so ostracized already that this solution is politically untenable, they are already fully-stretched and without resource capacity, so that when another firm crashes, the three survivors could not possibly pick up the pieces out of the wreckage. 

•    Q: If another firm is threatened with disintegration, how about replacing its tainted management with a credible outsider?

Q: As shown by the failure of Arthur Andersen despite Paul Volcker’s well-meaning initiative, the speed and complexity of a disintegration would out-strip any outsider’s powers or resources – see here.   

•    Q: In the end, won’t the regulators act to prevent the collapse of another global audit firm?

A: There is no more candid response than the concession of William McDonough as he neared the end of his term as chairman of the Public Company Accounting Oversight Board: as to what the regulators would do about another disintegration threat, “they don’t have a clue.”

These are sound-bites only, as I said, and I may have missed a point or two. Either way this compilation should be a good reference point. Please don’t hesitate to write with your reactions and suggestions.

BDO International and the Bankest Case – Another Nail in the Structure of the International Accounting Firms

When I first wrote last summer about the adverse jury verdict inflicted on the Seidman accounting firm in the Bankest matter in Miami, to the tune of $521 million – here – I suggested that it was the valedictory not only for that firm, but for the model of all the large international accounting networks.

Since then, Seidman’s pending appeal proceeds apace, and the firm survives –although with the ominous axe still overhanging, who knows what holds it together, other than inertia.

To complicate matters, the Florida appellate court’s decision of March 12 has now held that BDO International, the coordinating entity for the network of which Seidman is the US member, must go back for a trial that could hold it liable for the US firm’s astronomical damages.

The time required for this latest procedural wrangling will extend past the Seidman firm’s own appeal, so this new adverse development will not trigger the bullet aimed at BDO’s heart. That impact will be delivered by the resolution against Seidman itself – a critical link in the BDO network, but now hostage to a verdict far exceeding its capability to pay.

The forbearance of the plaintiff, Banco Espírito Santo, cannot be assumed; its lawyers will have a duty of professional advocacy to benefit their client, irrespective of the impact on Seidman’s viability. And like law enforcement agencies, plaintiffs’ lawyers are programmed by their DNA to carry out their mandates – for the former, prosecution where justified; in the civil system, maximum feasible recoveries.

What the appellate court has done is further expose both the fragility of the large firms’ international structures and the absence of achievable solutions.

So far as reported, Seidman’s engagements to audit Bankest had no cross-border aspects. But ominously for the large firms in their international practices, the Florida court essentially provided a blueprint from which other courts will look at the business reality and find a unity or integrity of interests.

Audits of complex enterprises simply cannot be done without some form of top-level management, whether across international borders or among several local offices. Mechanisms are required for standard-setting, communication and problem-solving – whether called control, oversight, or outright ownership.

In this case, the court looked at the international network’s articles of association, which had an objective to “manage and control” the BDO member entities; agreements providing international-level ownership and management of technical manuals and software; and public reports noting the implementation of international quality control and training programmes.

On this basis, the court has set up the prospect of a trial on the existence of an agency relationship between BDO International and Seidman, having found enough evidence indicating acknowledgment and acceptance of a right of control.

It has been advocated elsewhere – for example, here – that this recent decision calls for revision of the rules that limit ownership of accounting firms, and for opening them up to outside capital.

But that misses the point. As just noted, the issue for the court in Bankest did not involve the level or source of Seidman’s capital, or who could invest in a BDO firm, but the basics of operational necessity.   

And in any event, while the large firms run today on the financial support of their partners' capital, there is no feasible way to attract a level of outside investment sufficient to withstand the liability impact of worst-case claims -- as shown by the absence of available insurance manifesting that industry’s lack of enthusiasm for the accountants’ business model.

So revision of the ownership limitations to address cross-border litigation exposure is a futile undertaking, even if politically feasible, which it is not in the face of multiple and over-lapping regulatory authorities.

Defect-free audit performance is neither an option nor an achievable goal. A non-trivial number of audit failures are inevitable, as under any system designed and run by fallible humans. So nothing – short of fundamental re-structuring of all elements of the model for the delivery of financial statement assurance for large global companies -- can prevent the impact of another Bankest against the still-surviving Big Four.   

To Save a Collapsing Audit Firm? Leadership Replacement is a Non-Starter

On the troubled state of the large audit firms, it has perhaps been wrong of me to be so critical of the attention given by the various committees and think tanks, for their general failure to grasp the truly serious issues and the vacuity of their discussion – examples here.

Because – from a recommendation given by the US Treasury Department’s Advisory Committee on the Auditing Profession – when they do advance a substantive idea, it is so breath-taking in its misguided impracticality.

On April Fools Day that group put forward, in all apparent seriousness, the notion that the partners in the large audit firms, anticipating the possibility of a catastrophic threat – that is, a fatal litigation or prosecution – should voluntarily modify their agreements to trigger the replacement of their leadership. Or failing such a step, the Securities and Exchange Commission should be authorized to apply in court for a trustee.

The text of the recommendation – and, for the masochistic, the webcast of the Treasury committee’s March 13 discussion meeting – are available here. 

As Oscar Wilde described his reaction to a plot by Charles Dickens, only the truly hard-hearted can read this pathetic work without breaking into hysterical laughter.

First, who’s to decide? In the history of leadership, the concept of anticipatory abdication is a complete non-starter. Especially under challenge, leaders believe they can work through their crises, and will fight to stay in office. In the political sphere, leaders from Louis XVI to Richard Nixon to Robert Mugabe have shown the inability to anticipate their own downfall.

Business professionals are no different. Is it any more likely that the large-firm partners would willingly turn over their careers and their fortunes to an outside stranger, than that the shareholders or directors of Bear Stearns or Northern Rock – or, for that matter, of Enron or WorldCom – would have enacted advance terms for the displacement of their executives?

But if not done by leaders themselves, who would pull the trigger? An external decision-maker would have to be credible to all constituents, at least as informed as management itself, and presciently ready to act decisively at a moment’s notice. 

But the corporate world does not keep world-class crisis managers stocked in reserve. Anyone meeting those job requirements already has his energy and talents fully committed elsewhere.

Nor, paying respects to the grey eminences who populate the advisory committees themselves, is this a function to bolster the resumes of the retired. The learning curve of a real-time audit firm survival crisis would be too steep to be climbed by those for whom robust knees and lungs are the memories of youth.

As for the notion of timely SEC intervention, the Treasury Committee’s members themselves grasped at least two among the fatal flaws:

•    First is the issue of timing. The Andersen firm disintegrated in a matter of weeks in 2002, following the tardy but eventual capitulation of its CEO and an aborted effort to bring in outside leadership. Even the provisions of the US Constitution for the temporary transfer of presidential powers contemplate a timetable of four weeks or more.

•    Second, who is to recognize the need? The Public Company Accounting Oversight Board, regulator of the profession in the US, disavows responsibility for audit firm viability as outside its remit, and rightly so. The timing and scope of that body’s practice quality sampling program is already all it can handle.

Which leads to the unrecognized crux. The supposed rationale for a rehabilitation process is that new leadership might preserve a firm by dealing more successfully with its litigation adversaries or prosecuting authorities than those on the scene of the wreck.

But such a view, while real, entirely misses the broader point.

Namely, as should have been learned from the Andersen experience – or those recently of Bear Stearns or Northern Rock – the franchise value for those selling commodity products rests entirely on the preservation of trust, and not just on fresh negotiating positions or the appearance of new faces. Once the fuse is lit and a credible challenge to that trust has started to run – whether doubts about the “safety and soundness” of a regulated bank or eroded “client confidence” for an audit firm – it’s too late, and an explosion is inevitable.

Finally, it is argued that the SEC’s power to apply for a trustee – even if “in the pocket” and never expected to be used – would be an incentive to the firms to improve.

But again, that naïve view defies reality. The audit firms’ managements already know that they face death-threat exposures today. So if at the brink they would not be saved by SEC intervention – and when existing leadership will have been cashiered in any event – a regulatory tool that is both inutile and ineffective would, if anything, create a disincentive to constructive change. 

There’s value to wild and unworkable schemes – they can focus attention on what really can and needs to be done. This one has served its purpose – and can now be scrapped as it deserves. 

Auditor Concentration, Choice and Competition -- the GAO Takes a Pass

In the logging camps north of my little home village, lumberjacks teaming up on a two-man crosscut saw would admonish each other, “Either push or pull – just don’t drag your feet.”

Which on first glance would apply to last week’s report from the US Government Accountability Office, on the continued tight concentration in the market for audit services (here).

Despite re-affirming what has long been obvious -- namely, that almost all large public companies are audited by one of the Big Four firms, that audit fees have risen significantly in recent years, and that for global-scale companies, the option to choose among auditors is all but non-existent -- the GAO’s phlegmatic conclusion is that no compelling need for immediate action appears to exist.

So how well-deserved in the criticism of Comptroller General David Walker, head of the GAO – ranging from Paul Boyle, head of the UK’s accountancy regulators (here) to blogger Francine McKenna (here)? Can Walker really be expected to resolve the absence of client choice among the Big Four tetrapoly? Or to re-write fee levels, or to eliminate the threat to audit firm survival from ruinous litigation?

The concerns about large-firm fragility and performance do not lack for substance. The GAO’s sanguine view that audit quality has improved is already under challenge in the rapidly-growing population of subprime-driven litigations – a courthouse rush of new lawsuits marking a return to Enron-era levels (here), that to date sweeps in at least three of the Big Four along with clients of them all.

But to criticize Walker for foot-dragging is to mis-analyze the reasons for his diffidence.

The GAO makes a common but crippling error in its view of the impact of another large firm failure, on which more shortly. But its passivity is based in reality: it has available no achievable solutions, so its rational acknowledgement at least deserves recognition as credible.

That is because the critics of the current regulatory paralysis have no effective rebuttal to the GAO’s recital of the impediments to new entrants to the large-audit market:

First, the smaller accounting networks, suffering shortfalls in capacity, expertise and qualified personnel, lack either the interest or the risk appetite to take on audits at the Fortune 1000 level.

Second, proposed changes to allow outside investors in the accounting firms, with fresh capital to supplant the limitations of the private partnership model, cannot be shown either effective or beneficial. The firms don’t need, don’t want and couldn’t use the money, even if the bankers were prepared to take the risk, which they aren’t.

And, third, while the private market participants show their indifference to any initiative to help the auditors’ plight, beyond their own whining about limited choice, the menu of possible government actions is no more appealing.

That is, proposed official actions such as breaking up or spinning off parts of the Big Four, or requiring mandatory auditor rotation, or placing caps on auditor liability in hope of assuring their survivability, are all politically infeasible and potentially pernicious in their own unknown and unpredictable effects.

With the prevailing American political zeitgeist defined by populist cries for change, there is no chance of traction for either legislative or market-based relief in favor of a small cadre of high six-figure audit partners.

If the GAO stopped there, with its reputation behind an admitted inability to alter current conditions in any managed way, its shoulder-shrugging would at least advance the public discourse.

But its failure goes deeper – the same recurring flaw that runs through officialdom worldwide -- in the erroneous claim that the impact of another large-firm failure would be ameliorated by the relevant federal agencies. All three -- the SEC, the Public Companies Accounting Oversight Board and the Department of Justice -- are said by the GAO to be prepared to take various actions to help minimize the disruption to the market.

Walker and the GAO are wrong. There are no such preparations. The agencies are impotent. Out-going PCAOB chairman William McDonough admitted it in September 2005: “none of us has a clue what to do if another of the Big Four failed.” Unless there is a double-secret codicil to the GAO report, concealed somewhere in a bunker in a Washington file drawer, the same remains true today.

So the Comptroller General is merely acting out the bureaucrat’s classic rationalization of inactivity, in accordance with his basic genetic make-up: if nothing can be done, selling inaction as the best course becomes the strategy.

Or as baseball philosopher Yogi Berra would have put it, if the accounting regulators don’t want to solve the problems of large firm concentration and survival, nobody’s going to stop them.      

The Big Four's Litigation Cost: A Matter of Survival

What litigation cost would kill a Big Four accounting firm? Since this column first appeared, the responses have been remarkably quiet on two aspects: neither any disagreement with the shockingly small numbers, nor any credible claim that a political or regulatory solution is achievable. 

The Impact of Unheard Bullets 

Originally published in the International Herald Tribune on December 16, 2006

Business vocabulary borrows freely from the military: control battles, hostile raids, road warriors, chain of command.

Today's example is this axiom of warfare: "You never hear the bullet that kills you."

Last week I was with a retired partner of a Big Four accounting firm who has plenty of reason to be on full alert for silent killers: His pension is contingent on the doubtful durability of the large firms' cartel to audit the world's large companies.

The discussion of possible changes in the regulatory regimes for corporate financial reporting is rapidly expanding. It includes a full menu of ideas proposed in Brussels, London and Washington. But the reactions to any proposal for serious adjustment to the American auditor liability regime range all the way from lukewarm to downright hostile.

Those antagonistic views are based on the disbelief that there will be another collapse. That, in turn, is based on the persistently erroneous view that the disintegration of Arthur Andersen in 2002 was caused by its Enron-related indictment.

Hear this now: The unheard deadly bullet was Andersen's litigation exposure. And that has grave implications for the remaining Big Four.

How likely is it that another big- firm implosion could happen? As with Andersen, it would involve an emotion-driven breakdown in confidence — the simultaneous outflow of clients, collapse of an international network and flight of partners.

Although client flight will be severely constrained the next time around, with the lack of auditor choice available when the current Big Four drops to three, the other two factors can be quantified. And it's not a matter of exposure to prosecution.

While we await a promised talking paper from Charlie McCreevy, the European Union commissioner for internal markets and services (now available -- see here) , a supporting report prepared for him on Oct. 4 by London Economics, a consulting firm (here) , has calculated the size of the litigation hit that would disintegrate a large European linchpin accounting practice.

The report's assumptions, extended to the more threatened U.S. litigation environment, are truly scary in that they demonstrate the fragility of the large accounting firms' franchise.

To set the stage, recall that there are three reasons why the large accounting networks are forced to finance their large litigation settlements out of their partners' future profits:

First, by local codes they are barred from access to public shareholders or other equity investment.
Second, the partners' personally invested capital is on demand for working purposes.
Third, the insurance market no longer provides real risk transfer, but instead is at most a source of time- shifting finance.

The key to survival, then, lies in the willingness of the partners to stay committed and at their desks — something that the Andersen partners did not possess, as proved by the two- week period in 2002 during which they bailed out en masse and thus smashed the firm beyond recovery.

The study done for McCreevy calculates that the partners of a European firm would bolt, in numbers large enough to be destabilizing, rather than be forced to finance a litigation payment that extracted a profit reduction of 15 percent to 20 percent spread over three to four years.

Applying those assumptions to the Big Four's latest reported U.S. revenues of $4.7 billion to $8.7 billion (write me if you want to hear the numbers crunch), the dispiriting result is that the U.S. firms will confront partner flight and possible failure at liability levels as small as $450 million and up to $1.8 billion.

Those amounts are modest to the point of insignificance against the size of this decade's financial debacles — examples ranging from the $20 billion hole in the balance sheet of Parmalat to Enron's own $67 billion bankruptcy. Little wonder there is no public support for liability caps in the auditors' favor at levels low enough to protect them from collapse.

These assumptions also make plain that the Enron-inflicted blow on Andersen was mortal. The firm's 2001 worldwide revenue was $9.3 billion. It confronted plaintiffs' lawyers claiming that the case would be the first against accountants to reach $1 billion. The crippled firm was already dealing with claims involving Baptist Hospital, Waste Management and Sunbeam, and it was about to receive the incoming bombardment of WorldCom and Qwest, among others.

So to blame Andersen's death on the Enron indictment misses the point. The firm was like a terminal patient on late-stage life support who happened to succumb to a fast-moving staph infection: Its demise was imminent, and inevitable.

The report this month (here) to the U.S. Treasury secretary, Henry Paulson Jr., on a broad-ranging set of proposals for regulatory change,  notes that the Big Four's litigation inventory in the United States includes 22 actions, each with damage claims exceeding $1 billion — and that's without contemplating their lesser but not trivial cases, or the new matters that will inevitably arise in the months to come.

All of these will eventually be settled; witness the announcement last week that Deloitte will settle the shareholder piece of its Adelphia litigation for $210 million. Managements are too risk-averse to risk a life-threatening jury result at trial.

The Big Four might each survive one such impact from this barrage of lawsuits — although even that is a big if. But a second direct hit on any of them would be the last explosion they ever heard.

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 Survival of Seidman and BDO after Bankest

In the weeks since this column of August 18, Seidman and BDO have been keeping a brave public front on the effects of the June verdict of $521 million. But even assuming eventual success on appeal, their business challenges to maintain clients, personnel and partners through an extended process remain formidable.

For Auditors, Is This the Way the World Ends?

Originally published in the International Herald Tribune on August 18, 2007

In his 1925 poem "The Hollow Men," T.S. Eliot bleakly chants that the world ends "not with a bang but a whimper."

For large-company auditors and the fragile world of privately provided financial statement assurance, an ominous whimper was just heard in a courthouse in Miami.

In June, a jury of six citizens of Dade County, Florida, found that the Seidman accounting firm had been grossly negligent in the audit of its client E.S. Bankest, a Miami financial institution whose owners included the plaintiff, Banco Espírito Santo, which is based in Portugal.

On Monday, after one additional hour of deliberation, the jury imposed damages of $170 million on Seidman in favor of Banco Espírito Santo, adding the crowning touch of an extra $351 million in punitive damages on Tuesday.

Those are numbers well beyond the capability of the partners of Seidman, which reported total revenue of $589 million for the 2007 financial year. And Seidman won't be helped by its membership in a global network, BDO International, which - with about 30,000 employees and a combined revenue in 2006 of $3.9 billion - ranks a distant fifth behind the Big Four global accounting networks: PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, in order of size.

The Seidman firm has, perhaps quixotically, announced plans for appeal, but it faces a battle that's not so much uphill as up a cliff, and its future is, at best, mortgaged to that outcome.

Seidman could not possibly have wanted a trial over its Bankest audits. The plaintiffs claimed at trial that the audits failed to prevent or detect that Bankest, ostensibly a factoring company, was funneling funds diverted to its own principals - of whom the main players are either in or going to prison.

For Seidman, going to trial must have been an agonizing option of last resort, chosen only because it was unable to settle the case within bearable limits otherwise. Which is not surprising. Auditors have faced a formidable challenge defending themselves against claims they did not catch the bad guys, however pure their intent and skillful their efforts.

Juries have seldom been willing to look beyond the melodrama of seriously felonious executives. And in this America that increasingly elevates victim compensation to a social priority, Seidman's defense that it was competent but compromised by aggravated conditions was predictably unavailing.

Even more ominously, the Bankest verdict, which leaves Seidman and BDO teetering like a house of cards, casts doubt on the entire future of both the large global accounting networks and the one-page audit reports they deliver on consolidated corporate financial statements.

Since the disintegration of Arthur Andersen in 2002, the volume of commentary on the fragility of the audit reporting model has multiplied among the research groups and regulator-sponsored commissions.

But despite the noise levels, there have emerged neither strategies nor solutions for the threatened viability of the large firms in the face of death-threat litigation.

Topics in this dialog include the desirability of expanded competition for the Big Four, and increased auditor choice at the global company level. But the Seidman experience, which shows the smaller networks to be even more vulnerable than their larger counterparts, ends all expectation that a Big Fifth firm might emerge.

Never a realistic possibility in light of limits on the geographic and technical depth of the smaller networks, the idea is now as dead as Seidman's hopes for the trial.

Meanwhile, based on economic modeling done last autumn for the European Commission (here) ,  there is an estimated upper limit of $1.8 billion, or some €1.4 billion, that the partners' capital accounts of even the strongest of the Big Four firms might absorb without collapse. And the real survival risk threshold could be far lower, down in the range of $400 million.

But the impact can take the form of either judgments or settlements. While the Big Four firms have repeatedly shown that they could not or would not go to trial in cases at the level faced by Seidman, their payouts continue: Deloitte settled part of its Parmalat exposure this spring by agreeing with an administrator to pay $149 million, and in July, PricewaterhouseCoopers settled for $225 million with the shareholders of Tyco.

Yet nothing in the politicized debate on limiting auditor liability - whether in Brussels, London or Washington - suggests that lawmakers have any intention of providing the accountants with protection from litigation exposure at thresholds low enough to allow survival.

The Bankest verdict against Seidman was not the first shot across the bow of auditor survivability. That warning goes back to the disintegration of Laventhol & Horwath, a respected second-tier firm, under an adverse jury verdict in Texas in 1989. Ever since, the creaky vehicle of private audit assurance has been lurching along, always hostage to the next, and potentially fatal, blow.

As the number of firms still standing continues to shrink, the prospects for the survivors look increasingly grim.