Re:Balance -- Jim Peterson

Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations

“No such thing as a failed experiment …. only experiments with unexpected outcomes.”-- American engineer-architect R. Buckminster Fuller

 Is the Big Four’s concentrated control of large company audits a real problem? Persistent voices of concern and attention extend back at least to the 2006 study for the Financial Reporting Counsel (here), recently joined by global leadership of BDO and Grants (here and here).

If so, is there a credible case to incentivize their exchange of market dominance for liability limitations?

Those issues were addressed this month in a paper from the American Antitrust Institute – here. In an all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With pending claims totaling billions of dollars, the Big 4 audit firms face serious threats to their survival…. (L)iability exposure substantially exceeds the combined partner capital of the Big 4 firms… (They) contend that liability limits are necessary to prevent the loss of another Big 4 firm, which would throw the global financial system into chaos. (footnotes omitted)   

The AAI’s suggestion would be a legislated trade-off: “government incentives to break up the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned on a firm divesting itself of, say, 20% of its domestic revenue and the personnel serving the surrendered clients.

Can’t work – because of the many problems with the underlying but unachievable assumptions. 

But before getting there -- the AAI deserves credit at least for recognizing the completeness of the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250 million” (emphasis in original) – with even tighter limitations on auditor choice in such industries as metals and mining, energy, air transportation and financial services.

Start with the political unacceptability of liability capping at a level that can assure Big Four survival. I have spelled out before (here) the financial limits of the large firms’ private partnership structure and their membrane-thin working capital, under which they cannot withstand litigation shocks above the $1 - $2 billion range – a tiny fraction (by either amount or percentage) of the exposures in their pending lawsuit inventory.

As the AAI paper summarizes, critics of liability protection point to the firms’ average litigation payouts, as a percentage of revenues and as compared to the far larger total of alleged damages. They fail to recognize – as do the arguments for capping from the profession itself -- that averages are meaningless when the “outlier” of a single verdict, falling outside the misleading comfort zone of a bell-curve model, could and would be devastating.   

So: because American politics offers no cover for protection at those levels, that side of the proposed AAI bargain is no solution. What of the other side -- the plausibility of large-scale competitors emerging from the suggested divestiture program? The facts dictate otherwise.

First, an abundance of small practices already exist. Why they have not coalesced into global-scale practices is a long-familiar story of limited geographic scope, expertise, risk appetite and readiness to invest.

Second, the smaller sector does not inspire confidence in its strength or capacity for quality growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a deathwatch, facing the post-appeal enforceability of its $521 million jury verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins just received a seven-year prison sentence – now faces the fall-out of being fired by Koss, its public but family-dominated Milwaukee client, whose CFO managed for years to steal amounts in excess of the company’s total net revenue (on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a practical matter, how would global-scale competition emerge? If a Big Four firm were to hive off a small geography-based practice, that newcomer would suffer handicaps of capacity and expertise no different that those of the current smaller firms.  If a large firm were to shed an entire industry practice, no new competition is added to serve that industry. And if instead, it were to divide a viable large-scale practice, then each of the two sub-practices would be burdened with shortages of expertise, personnel and the capital strength necessary to build to scale and withstand their risks.

In summary, the AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in logic I described (here) in the comparison of a failing situation against an idealized state, without recognizing that the assumed achievement is impossible under real-world limits, flaws and constraints.

The large firms grew that way for service-based reasons. And dreams of expanding the population of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the AAI’s most seriously under-examined assumption is that the “catastrophic” disintegration of another Big Four firm “would throw the global financial system into chaos.”

Why so? To the contrary, if the now-standard auditors’ report were suddenly not to be obtainable from any source, who would miss it?

Regulators and politicians would have convulsions, to be sure. But as the financial crisis itself has shown, that is daily practice for office-holders in the hermetic confines of Washington and London and Brussels.  

Should the stock exchanges be closed, if a Big Four failure meant that one-quarter of the large listed companies lacked an audit report? Could those companies’ securities be barred from trading? Unthinkable. Out where capital really flows and trade is actually engaged, the world’s markets would shrug, start the process of designing new forms of assurance from a blank page, and move on.

And the splintered pieces of the former Big Four would provide ample building blocks for a new assurance structure – without, pace the AAI, any need or use for the unintended and unpredictable hazards of another failed experiment.

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Auditors Missing in the Financial Crisis -- Readers Offer their Thoughts

To greet the new year, instead of a backwards look at a dreary 2009, this will revisit last month’s lively exchange, initiated by Francine McKenna’s provocative post of December 7, “They Weren’t There: Auditors and the Financial Crisis.” My response of December 13 is here, and hers of the 14^th is here.

Highly compressed, the gist of our mutual concern is, as Francine put it, “the auditors’ failure to be a force either before, during, or after the financial crisis.” The depressing explanation, said I, is that “their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism – having lost any value it may once have had, except for legally-required compliance.”

Our invitation to a conversation drew forth an exceptional level of reader interest and a cascade of comments. They ranged from the acute and perceptive to the callow and credulous – but all were seriously intended and deserve broader exposure and responses.

So picking a sample of some half dozen, and inviting the discussion to continue: 

PF noted to Francine that “the idea has been floated of having each exchange traded company purchase insurance against the financial impact of future restatements or fraud, but for that to work you would merely replace the auditors with the insurance industry, who would need to do their own “audits” before they would agree to underwrite such large risks.”

And David wrote similarly, that, “maybe each firm performing audits should have to put up a bond that would be available to creditors in the event of malpractice lawsuits. Let’s say that bond was equal to at least two years of the firm’s audit revenues. … You could even have an experience rate type of adjustment….”

Sorry – we've been there. If feasible, the idea of outside sureties would already be in place by now (here). The marketplace reality is that the insurance industry – which suffered massive losses on its coverage of the accountants during the savings & loan debacle of the 1980’s – learned enough to avoid a repetition.

It’s not just that the Big Four tetrapoly fail the essential tests of insurability, although they do – because of sector concentration, unpredictability of losses and inability to quantify exposures. It’s also that if any such “super-audits” actually existed, the auditors would surely be performing them already. The sad fact, instead, is that the poor profession is operating today to the best of its unfortunately limited capability.

On user expectations, Robert accurately observed that, “an audit is supposed to provide reasonable assurance, not absolute. An audit firm has many engagement teams…some good…some bad. The whole system can’t be vilified because of isolated events.”

“Vilified” – perhaps not. But it is precisely the isolated events – highly-consequential and destructive as they can be – that will bring down another large firm.

On this there are two points: First, because the accounting profession lacks an effective forum by which to scrutinize and learn from its failures and short-comings, it has been unable to avoid repeating the same performance deficiencies from one generation to the next. It's a failure in historical perspective, to miss the instructive comparisons between Parmalat, say, and Equity Funding – or between Satyam and ZZZBest.

Second, the community of financial statement users is unimpressed by the profession’s proclamations of its successes. Virtue is not preserved by an accumulated preponderance of generally good behavior – rather, it is dissipated and lost altogether by individually corrosive, culpable acts. For most of their life spans, John Edwards and Tiger Woods were credibly decent – as were Jimmy Cayne and Dick Fuld and even Conrad Black and Bernie Ebbers -- except for certain nasty instances when they were not.   

I had this note from JD: “The auditors were there and just got it wrong. They will feel the pain from this trying to defend the lawsuits. Whether they can be successfully sued is another matter. If one or more big firms fail as a result then so be it. In the long run there are enough other audit firms who will eventually step up.”

The problem is the last sentence. Under the large firms' presently dysfunctional model of litigation exposure, independence constraints, limited capital and concentration of resources and expertise, it is just not the case that alternative providers might emerge to replace a failed Big Four firm. That discussion can be expanded at greater length, and has been, but the only answer is "no way."

Francine had this interesting proposition from TT:  “the first firm to focus on quality, and to deploy and consistently follow standards that enforce quality regardless of other factors and metrics, will rise above the others. … But the sad fact is right now that the clients don’t perceive any differences between the firms, and it would take a significant difference to catch the clients’ attention.”

The standard audit report now being an undifferentiated commodity, TT’s point was answered by Geoff, who wrote that, “From 1933 until now, there hasn’t really been a evaluation of the core assumptions around audited financials. The requirements have evolved and become more detailed, stringent, as we go through the motions of continually fighting the last war. Add to it the institutionalization of the main players (audit firms, regulators, accounting designation self-regulatory bodies), and it’s easy to see how we’ve lost the plot.”

To conclude, the widespread inchoate desire for “something better” resounds in Esa’s plaintive note:

If you know of a better model that allows us to hold someone responsible for unforeseen future events, I’m all ears but that’s not a job I want.

A lot of people think the model is relevant though it certainly has flaws. The SEC, institutional investors, financial analysts, etc. all think the model requires tweaking but none suggest wholesale changes.

If fact, I haven’t heard anyone propose something that even comes close to a reasonable alternative that is actually feasible. If you have ideas on that front, please share them.

That’s an echo of the call from Francine and me. Progress will come neither from the self-interested parties' reticence to “suggest wholesale changes,” nor their continued pointing of fingers and weapons. Instead, as a first step at least, let the wide-open conversation continue.

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Invitation to a Conversation: If the Auditors Were Missing from the Financial Crisis -- Let's Ask Why

 

Last night I saw upon the stair

A little man who wasn’t there

He wasn’t there again today

Oh, how I wish he’d go away

 -- Hughes Mearns, 1899

 An under-appreciated power of the bloggers is the capacity for a two-way conversation, right out in full public view.

 That was my reaction, anyway, to Francine McKenna’s December 7 post, “They Weren’t There: Auditors and the Financial Crisis” – the gist of which is that the Big Four firms, who audited every one of the institutions complicit in the financial crisis, have been absent not only from visible influence on the catastrophe, but also from the post-mortem recriminations and accountability.

 Any regular reader here should also be subscribing to Re:The Auditors, where Francine airs a central theme:

“The auditors should have been there, as a last stop, where the buck should have stopped, as gatekeepers, watchdogs, advocates, and the last bastion of standards and expected values shareholders can look to.”

Here – in response to the always tart-tongued Francine -- is why the auditors weren’t there:

The simple if depressing reason is that their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism -- having lost any value it may once have had, except for legally-required compliance (here). 

If that single page disappeared from corporate annual reports, no honest user of financial information would admit to missing it. Nor, offered the choice, would any rational CFO pay the fees to obtain it.

There is plenty of assurance that users would value and pay for – that much is clear from the debates about the largely unrealized usefulness of reports on governance, sustainability and intangible assets outside the scope of historical cost-based reporting (for specifics, this column of mine goes back to April 2006).

But not in the current liability environment, where the large accounting firms are captive to their business model and paralyzed from innovation by their twinned lack of vision and influence.

On the other side, the regulators’ mantra that “audits are essential” is no more than the unexamined and self-reflexive assumption that audit reports will simply and always be there – like air or water or electricity. Whereas, if another fragile Big Four firm does trip into disintegration, nothing within the capacity of any regulator on earth will be able to put the shattered networks back together again, or compel the delivery of audits when there is nobody left to perform them.

If there is to be an adult conversation around this issue -- and along with Francine, there are real participants -- for general examples, Tom Selling's stimulating Accounting Onion, Dennis Howlett's acerbic AccMan, or Richard Murphy's Tax Research UK -- there are at least three other chapters to be aired, at whatever length is needed for credibility:

First, it is past time to put final closure to the talk of unachievable structural “solutions” to the Big Four’s complete dominance of large-company global audits. None of these can happen – as sketched out here – whether it be growth to competitive scale of a Five or Six, break-ups to restore a new but even further weakened Eight, mandatory rotation, new insurance or outside capital, liability limitations, or government take-over of the entire function.

Second, the financial structure of the private Big Four partnerships must be recognized as too weak and limited to sustain their current exposure -- here. Unlike the banks, their franchise is not “too big to fail” – the question is whether there is a better cliché than “too weak to survive.”

Finally, as a message to the Big Four leadership who have no choice but to get out in front, the private sector must acknowledge that no help will be forthcoming from government. Legislators – whose essential DNA bars them from any activity other than belated over-reaction – cannot be counted on for anything other than interference (here).

Worse, coordinated regulatory strategies are impossible at the global level – witness the floundering over GAAP / IFRS convergence as a simple example – while in the United States, a populist-oriented administration is not about to provide relief to a white-collar profession perceived to be overpaid and under-performing.

So there is no falling back upon the fallacious assumption that “’they’ won’t let another firm fail.” There is no “they” – no regulator or politician with the vision, interest or authority to prevent a debacle.

Francine’s massive army of readers is a potential force to be reckoned with – and has plenty at stake, whether as practitioners with careers-at-risk or users in search of better quality financial information. 

With their engagement, the evolution to a sustainable, achievable new model of reporting and assurance is possible – however unlikely, absent real commitment to a fresh and holistic approach.

But the dialog has to move beyond whiny finger-pointing, and the simplistic recitation of unrealistic “solutions.

And the sooner, the better.  

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Which Large Accounting Firm Will Be "Next to Fail"? It's the Wrong Question

When was there ever so concentrated a burst of public speculation on “which Big 4 audit firm is the next to fail”?

Within a single week, Accountancy Age predicted it would be Ernst & Young; in the blogosphere, Francine McKenna’s wager with Dennis Howlett fingered her ex-employer and bête noire, PwC; and ProPublica reached into the remains of the second tier to round on McGladrey and BDO.

All for very serious reasons, ample to cause sleepless nights among the profession’s leaders. But the voyeuristic speculation as to “which one” is a pointless and mis-directed exercise, because each of these firms – but also Deloitte and KPMG, and Grants too, for good measure – faces multiple overhanging threats on a mortal scale.

All the chambers are loaded in this losers’ game of Russian roulette. So it is an unanswerable question, where the weapon may be pointing when the hammer falls next. It’s also an irrelevant query, too – because it depends entirely on the judges’ docket management on Parmalat, Satyam, New Century, AIG, Bankest, Refco, Sentinel, the Madoff feeders and all the other ticking time bombs.

Instead, the real question should be, “What next?”

On this, for grown-up dialog to occur, two fundamental misconceptions – both lurking in the Accountancy Age article – have to be killed off, once-for-all:

The first is that the large firms’ survival will somehow be assured by government, on the assertion that global-scale companies “will invariably have a legal requirement for an audit.”

If there is any logic here, it is seriously inverted. The regulators long ago conceded that they would be powerless to stop the disintegration of a large firm that reached a tipping point – here and here. Further, when that next step takes down the other three, and unravels the entire suppliers’ market, legislative mandates that there be audits would be as futile as a requirement that all trains be hauled by steam locomotives. No more suppliers: no delivery. Period.

The second fallacy, conspicuous even in an article that displays a truly stunning lack of comprehension of the profession’s structural issues, is that a Big Three would survive the loss of a fourth.

Won’t happen. The uneven concentrations of industry expertise around the world’s large economies, the politically-imposed constraints on auditor choice, and the post-Andersen fragility of the international networks are alone sufficient to show that the Big Four are already down to an irreducible tipping point. One more, and they all go.

While no insider will say so in public, senior risk managers acknowledge that in the coming turmoil of another Big Four failure, the prospect that three survivors would stay in today’s business by accepting further concentration of exposure and liability will be untenable.

That a fundamental re-structuring of the profession will occur is beyond debate – and is nothing new – although answers will only lie in the readiness of all interested parties to get past the posturing to offer constructive, achievable solutions.

Trouble is, none of the critics have either the vision or the authority to lead. There is no available government intervention, to “save” a privately-capitalized Big Four partnership once slipped into a death spiral – here. Nor can the large firms’ collective survival be enabled by statutory requirements that there be audits; if a firm goes down and takes the others, it is as futile as King Canute’s attempt to order the tides, to require delivery of an audit report when the providers are all out of business.

The only alternative to a highly-disruptive disintegration of the large firm networks – and a long shot wager indeed, requiring the most wild optimism to imagine – would be the emergence of Big Four leadership prepared to engage, for the sake of their future, in the “creative destruction” brought forward in 1942 by economist Joseph Schumpeter:

•    To forswear the currently outmoded auditors’ report, which provides no value to the market and is toxic to the sustainability of the firms’ business model.

•    To cut to the heart of the critics’ animosity, by the deep finesse of voluntarily turning the task of issuing low-value “compliance assurance” over to nationalized agencies.

•    To allow the capital and investor markets to ascribe to “compliance audits,” performed by huge cadres of conscripted civil servants, the nominal value they would deserve.

•    To empower the surviving firms to invent, sell and deliver new forms of assurance that companies will buy, and the markets will pay for, under sustainable limits on liability and free of the life-threatening legal exposures as wielded by the class action plaintiffs.

•    To break the antiquated shackles of the compliance-driven limitations of “independence,” so as to build or acquire whatever professional services capabilities may be congruent with the new forms of assurance – whether in systems or technology consulting, finance, law or otherwise.

Starting down such a road would require envisioning an entirely new set of directions for the profession – beginning with the acknowledgment that the current race is going around a one-way track to a dead end. 

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Where Else Does Size Matter? Audit Firms, and the Experience in India

Suppose a law that limited the height of professional basketball players to six feet. Or that forbade the performance of Beethoven’s symphonies by groups of musicians larger than a trio.

However able the players, the performance quality would be inferior. Discerning customers would flee in multitudes, for venues freely offering the unrestricted alternatives.

Independent audit has evolved a great deal since the winter of 1850, when sole practitioner William Welch Deloitte delivered his first opinion on the financial statements of the Great Western Railway.

Today the surviving Big Four – Mr. Deloitte’s namesake, along with Ernst & Young, KPMG and PricewaterhouseCoopers – collectively comprise some 593,000 personnel, and have worldwide annual turnover of $103 billion. The foursome together have a lock on engagements for global-scale companies in the developed economies – doing the audits, for example, of all but a handful of the S&P 500 in the United States, all of the FTSE 100 in the United Kingdom, and (with the involvement of some smaller firms as joint auditors) all of the CAC 40 in France.

Ample justifications are offered – scale, technical expertise, cross-border client demands, and uniformity of standardized practices being the usual rationales. On the other side, careful risk managers at the smaller networks are ready to concede this high-risk territory to their larger brethren, competing at levels where complexity and exposure are, optimistically, more manageable.

There being no cogent case that the smaller audit firms deliver better quality than the larger, an argument in favor of scale lies in the recent disasters: critics of the still-emerging schemes of Bernard Madoff and Allan Stanford are quick to point out that each employed tiny audit firms, lacking visible signs of personnel or qualifications, or indeed even appropriate licensing compliance.

Still, vestiges of the Victorian era of Mr. Deloitte’s start-up do survive in the profession’s structure and attitudes. The visible current example is in India, where the governing rhetoric is dominated by the small firms’ unexcepted hostility to the Big Four – even ahead of this winter’s demonization of PwC over the $1 billion debacle at Satyam Computer Services Ltd.

As a legacy of an earlier and simpler provincial time, audit firms in India have been capped at no more than 20 partners, each allowed to sign no more than 30 reports. All very well, for an economy comprising thousands of store-front enterprises – served in India by as many as 45,000 little accounting practices. But hardly does this suit the demands of global-scale enterprises, where even the members of the so-called “second tier” continue to lose market share to the largest networks.

Overseers of the profession, including the Institute of Chartered Accountants in India and the Ministry of Public Affairs – with the combination of bombast and naïveté that is characteristic of officials extended beyond their vision or their competence – have responded to Satyam with a variety of retrograde proposals, including mandatory rotation of audit firms and a blacklist for firms under investigation -- see here, here and here – also scrutinizing such superficialities as the firms’ policies on paid leave and Institute seminars.

The first of these is already discredited by the example in Italy – the only developed country with experience. There, mandatory rotation only increased the Big Four’s market concentration, and the consequent division of responsibility between Grants and Deloitte arguably contributed to the on-going misbehavior at Parmalat.

And if the punishment of a blacklist were applied ahead of the conclusion and final judgment of appropriate enforcement proceedings, it would only perpetuate the lack of due process manifest in the continued imprisonment of the still-uncharged and presumably innocent Satyam engagement partners from Price Waterhouse.

As well observed in the natural sciences, evolution is a force that will not be stopped. It can only be diverted or stalled temporarily – through artificial means, political resistance or subsidies and expediencies.

Still, the trend to large-company auditor concentration has been inexorable for decades elsewhere, and is already well on display in India: at last available count, of the 300 largest corporate enterprises not under Indian state control, 178 were audited by a Big Four firm (of which 24 included a smaller firm along for the ride as joint auditor).

The lessons of Madoff and Stanford speak loudly to the credibility of small-shop audits for large-scale situations. “Small is beautiful” cannot be established by the claim that sometimes “large may be ugly.” Those positioned to shape the future of the profession in India will eventually be obliged to take heed.

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Audit Firm Survival -- Is Government-Backed Insurance at the Cutting Edge?

Considering the vacuity of the debate on the survivability of the Big Four audit firms and the delivery of audits to large public companies, especially at official levels – see here – there should be full exploration of all ideas that at least pass a laugh test.

So I was tantalized by Tom Selling’s suggestion last month (The Accounting Onion) to reincarnate a “Big Eight”, if “the government could offer to share the litigation exposure from each of the Big Four’s prior audit engagements in exchange for [their] splitting up into two completely separate firms.”

Well, maybe. But anyone thinking that large-company audits would be helped by hacking up the large firms should consider this tool: the razor named for 14th century English friar and logician, William of Occam, whose rule of succinctness states that all things being equal, the simplest solution is the best.

Beyond the purely political issue that auditor liability reform is an officially toxic topic in Washington, and the absence of any legal foundation for such slicing and dicing, there are some practical issues:

First, unless the Big Four bifurcate their industry teams, no new competition would emerge. That is, if a current Big Four health care or insurance practice spun off as a whole into one new firm, while its technology or energy practice stayed intact but went to another, the range of auditor choice within an industry would not be expanded.

And the glacial and ineffective pace of change within the profession itself makes it unlikely that senior experienced audit personnel would have the incentive or take the initiative to re-tool their expertise from one industry over to another.

On the other hand, however the Big Four firms might be broken up, it would not reduce the complexity or resources needed to audit a large global company. For example, each half of a firm’s split-up banking industry practice would still require a full-bore set of technical and regulatory expertise. With the loss of economies of scale, duplicating such competence would reduce efficiency and increase rather than reduce the cost of large-client engagements.

Relatedly, on the issue of performance quality, Selling suggests that the Big Four may have grown “too decentralized to control.” But to serve global companies, Big Four practices riven in two would still need a serious presence in all the countries where their clients require service. That challenge of scope, scale and resources is not solved today by the Big Four’s smaller brethren – and would present an immediate quality challenge to any Big Four offspring.

Which asks the question whether division would be desirable beyond the US, in countries deemed to be low risk. Are there any candidates? Significant litigation now originates in engagements or companies as far-flung as Italy, the Netherlands, Russia and South Korea. So countries attractive for firm mitosis may be few indeed. And with one or two of the Big Four typically dominant in the larger non-Anglo countries, division of the firms only in the US might well have perverse effects on concentration elsewhere.

As for the economics of a bail-out, leave aside the political improbability that government would assume a litigation exposure currently estimated to exceed $100 billion. True, the cost of a rescue would be chump change compared with the taxpayer burden looming over the impending rescues of Fannie Mae and Freddie Mac – but public passions are far less aroused for auditor salvation than for the country’s dominant home mortgage institutions.

The idea is a non-starter for other reasons, starting with the impracticality of doing a “one-off.” That’s because protecting the Big Four from today’s catastrophic litigation threats does nothing for the future. Any new mini-firm would, post-split, still be exposed to the next generation of cases that – based on four decades of experience – will inevitably arise.

And it would not bode well that smaller, capital-challenged new firms would have only half the financial resources they do now, when they are already facing litigation-driven extinction.

There is one positive glimmer in the heart of Selling’s idea – a stand-alone government assumption of the large firms’ catastrophic exposures.

Today the Big Four are forced to settle their biggest cases. They lack either insurance or partners’ capital robust enough to take the non-trivial risk of going to trial and incurring a punishing adverse outcome.

It cannot be imagined that politicians would create a $100 billion honey pot for the investor plaintiffs and their lawyers to dive into. But there could indeed be created a federally underwritten catastrophic re-insurance mechanism or “litigation trust” – which as a form of contingency capital would enable the firms to litigate their cases without fear of a death-blow verdict.

If such a lifeline were available, it would obviate the viability threat. So simplified, the very reasons for the otherwise impractical Big Four split-up go away. The firms in their current form could then address their twin goals of quality and relevance, without the distractions of imminent overhanging bankruptcy proceedings.

Using Occam’s Razor to pare away the parts that fail to benefit audit delivery effectiveness, the Selling proposal suggests a financial buffer worthy of consideration.  That idea would logically be housed in the proposal I outlined on June 10 – here -- for a government-sponsored structure of charters for firms doing audits of publicly-traded companies.

So let the discussion continue.

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.

The Accountancy Regulators -- Motion Is Not Progress

My last post, critical of the proposal from the SEC’s Committee on Improvements to Financial Reporting for a “judgment framework” for accounting and audit decision-making, generalizes across the lack of substantive debate on the difficult state of financial reporting and the auditors’ threatened assurance franchise.

More public meetings are on the calendar – specifically, the US Treasury’s Advisory Committee on the Auditing Profession meets on March 13 (here), the CiFIR itself meets the next day (here), and the US Chamber of Commerce's Center for Capital Markets Competitiveness holds its next annual summit on March 26 (here). The hot-air potential is high -- the optimism level is not. A catalog of inter-related issues remain completely unresolved, without any visible progress against an agenda laid out in this still-relevant column that ran in the IHT on April 22, 2006:   

Solutions That Are Not

There's no finding solutions without a proper focus on the problems. Think of the guy in the dark of night, searching under the street lamp for his keys. The beat cop asks, "If you say they were lost over in that dark alley, why are you looking here?"

"Because the light's better here," the poor guy responds.

Which pretty much describes the January, 2006 report of the U.S. Chamber of Commerce, joining the dialog on the survivability of the large accounting firms under the stunningly obvious title, "Auditing: A Profession At Risk" -- here.

With its heart in quite the right place, the group says "action must be taken" so that companies might retain "access to high-quality, reasonably priced auditing services."

Whereupon, sadly, the report loses its focus and its way, bumping dimly down the dark streets from one missed opportunity to another.

Here are six of them:

First, the chamber gamely recognizes that the audit profession has become effectively uninsurable in the face of litigation costs that threaten immediate destruction of partners' limited capital and their long-term inability to hire and retain personnel.

Yet its limp observation that legal reform "may be needed" misses the crucial point. Auditor insurability requires the ability to predict, quantify and limit the insured risk - conditions impossible to fulfill under unlimited liability hazards.

Second, the chamber repeats the familiar if unhelpful refrain that auditors should not be held liable for failure to detect or prevent cleverly designed collusive fraud.

That's fine, as far as it goes. But what about the many corporate frauds that aren't that clever or well concealed, but that repeat shenanigans perpetrated for generations? And what about all the "fraud" that consists of aggressive use of permissive accounting standards set under the influence of corporate interests themselves?

Also, what about auditors who, faced with a crushing liability overhang, are forced to settle their mega-cases without going to trial?

Third, the chamber proposes that the Public Company Accounting Oversight Board, the U.S. industry regulator, should promulgate a "safe harbor" standard for fraud detection, to protect the auditors if they can show they fulfilled steps issued by a bureaucracy.

Yet it is this very "check the box" approach to the control assurance requirements that is the Achilles heel of the Sarbanes-Oxley law. Companies whose stock trades on U.S. exchanges, and therefore must register with the U.S. Securities and Exchange Commission, are furious at the escalated cost and diminished effectiveness of auditor performance because of the Sarbanes-Oxley requirements - to the point of avoiding or fleeing U.S. listings altogether if they can.

Fourth, the chamber serves its own broad constituency of small businesses by suggesting that the audit profession's doubtful viability is not helpful to new companies that may be innovative but unfamiliar to the capital markets.

Trouble is, that's not where the real threats lie. It's not the unknowns with the biggest and most costly claims in this decade, but household names: Enron, WorldCom, Adelphia, Xerox and Parmalat.

Fifth, understandably exercised over the mortal blow of the indictment of Arthur Andersen over its work for Enron, the chamber calls for legislation to "rein in" the process of indicting whole enterprises.

Here the problem is that unless world trade and commerce unexpectedly achieve an as-yet unknown state of grace, society will expect its law enforcement officers to indict and prosecute where indicated by the facts.

Sixth, the chamber joins a chorus of concern over the shrinkage down to the Big Four, who together audit virtually all of the world's largest companies. But the relocation to smaller firms of non-audit work is once again off point: Those are not statutory compliance services, where the real legal risks and fatal exposures lie.

To be fair, though, the chamber may be so turned around because it started from a faulty bearing - that auditing is central to public confidence in the capital markets. When the next big auditor disintegrates amid litigation, it will become obvious that the delivery of services by a noble profession in the process of collapse will not be something anyone will be able to preserve.

In the small pool of light cast in this darkness, that much is right out in plain sight.

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.      

Big Four or Mid-Size -- Can the Regulators Save the Accounting Firms?

Can Midsize Auditors be Turned into Big Ones?

Published in the International Herald Tribune on October 20, 2007

Cinderella has been invited to the ball. Or so you might be tempted to think, if you were the leader of a middle-sized accounting firm.

Tuesday saw the release of "Choice in the U.K. Audit Market," a report from the profession's regulator in Britain, the Financial Reporting Council. To give large companies a greater choice of auditors, the FRC - playing the role of Fairy Godmother - proposes to allow any firm smaller than the dominant Big Four accounting networks to be hired to audit the largest companies, releasing them in the process from their perceived state of drudgery and inferiority.

The FRC would make the smaller firms more attractive by opening their ownership to the outside capital needed to expand their capacity, and by jaw-boning both large companies and their bankers into offering audit work to these newly empowered firms.

Trouble is, the historic trend goes straight the other way. Audits for large companies are dominated by the Big Four, including all of the FTSE 100 in Britain. So although the FRC explicitly plumps for "market-led" solutions to this state of concentration, the market's own reaction has been a kind of cringing distaste - sort of like when your best friend asks you to take his little sister to the dance.

Also, there are signs that the mid-sized firms themselves may not be quite up for the big partying. Instead of standing alone and growing beyond the current limitations on their geographic scope and economic strength, as the FRC's program would encourage, the smaller firms are moving in the opposite direction.

In France recently, the Constantin network - 30 local firms spread over 60 offices - forswore its middle-market niche to unite its 500 employees with the 5,000 at Deloitte. In Britain, the RSM network has seen its affiliate Robson Rhodes run off into the arms of Grant Thornton, the No. 4 firm.

The FRC's second concern - to reduce the risk of another large-firm collapse, or to mitigate the effect if that should happen - is even chancier than the smaller-firm issues.

Despite the good news that the judge handling the Parmalat litigation in the United States has thrown out the claims of non-U.S. plaintiffs, Grant Thornton, whose Italian affiliate had been Parmalat's auditor, still confronts potentially deadly litigation from the collapse of Refco, the high-flying commodities broker in Chicago that Grants picked up as a client after the demise of Arthur Andersen in 2002.

I spoke this week with Paul Boyle, chief executive of the FRC, from his office in London. Boyle's modest aspiration is that the report's recommendations might make the world of financial assurance "a little less risky, and a little safer."

He has in mind the real probability of the disintegration of another large network, like Laventhol in 1989 and Andersen in 2002, under litigation liabilities that their capital cannot cover. That brings to the fore the prospect that a loss of another of the Big Four would lead not to a sustainable Big Three, but "four-to-zero" - a complete
collapse of the franchise of large-company audit assurance.

To prevent or mitigate that result, the regulators' available tools are "very limited," Boyle acknowledged. And as the recent tumult in the credit markets has proven, when a meltdown is underway, neither regulators nor the elusive "market" are always capable of bring things back under control.

Instead, if another Big Four collapse is imminent, Cinderella's coach becomes a pumpkin again - there being no agency or authority with the vision, the interest or the capability to stop it.

So take the FRC report as serious bedtime reading. And sweet dreams.

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.