Re:Balance -- Jim Peterson

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•    That the traditional form of auditor’s report is obsolete and provides no investor value, especially compared to the possible forms of assurance that are impossible under the current model -- here;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