Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

So what is needed is a different cliché.

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

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

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

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

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

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

This one comes straight from the heart.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Insurance to Save the Auditors -- Yet Another Non-Starter

This column was originally published in the IHT on August 27, 2005. With other related work in the pipeline, I pick it up now mainly for archival reference, although -- with apologies for the anachronisms --  it remains just as current today as it was then.

Plot Twist Hits Reality

This has been a good summer for melodrama. First, there was Steven Spielberg's film "War of the Worlds," with its specter of alien invaders. Then there was "Attack of the Giant Liabilities," with the mega-settlements paid by banks in the Enron case - and the prospect of more to come in the cases of Parmalat, AIG and others.

The movie's hero was Tom Cruise. No similar savior exists for the Big Four accounting firms, beset by performance worries, liability overhang and structural threats to the viability of their core product, the standard audit.

But as part of a healthy debate over the future of the profession, a proposal was floated in July by a fellow columnist, Joseph Nocera of The New York Times -- here: Corporations would buy an optional "audit insurance," which their insurance companies would issue after a new and separate form of audit examination. This new coverage would, in theory, protect shareholders from losses resulting from faulty auditing.

An entertaining idea. But is it realistic? A few questions to explore:

Are there accounting firms available to do this new work?

The U.S. Securities and Exchange Commission and other regulators are not willingly going to surrender their requirements for standard audit reports, so companies would have to find a second accounting firm with the skills and resources to perform the new audit. That, by definition, means another member of the Big Four: PricewaterhouseCoopers, Ernst & Young, Deloitte & Touche and KPMG.

The problem is that most Big Four clients - after eliminating their current auditor and any firms of which they are consulting clients - will find there is at best only one other firm eligible to bid for new work. This was shown last autumn when Fannie Mae had nowhere to go but Deloitte after firing KPMG. The choice, already poor, threatens to become irreducible.

What about personnel?

The Big Four firms are already operating flat out, to the point of staff abuse, under the burden of work required by Section 404 of the Sarbanes-Oxley Law, and they are hiring workers as best they can to replace those they chew up. It is not a recipe for success to think that they could ramp up further, to perform a new, high-value service with workers hired from the next lower level of education and professional competence.

If the current audit firms took on a new role, what additional work would they do?

Auditors today already put their reputations and their survival on the line by issuing opinions that financial statements are free of material error. There simply is no more or different work they are competent to do - either to bolster that opinion, to manage their overhanging catastrophic litigation exposure, or to entice the insurance companies. Because if there were, they would be doing it.

Would the numbers work out?

As Nocera recognized, the problem is one of scale. Audit insurance would never cover an Enron-like debacle - namely, investor losses from a $67 billion bankruptcy. But in positing that the new coverage would be more than enough for shareholder losses from bad audit news, he misses two key points.

First, in the U.S. legal system the auditor can now be held liable for 100 percent of all investor losses, even in a large-scale debacle like Enron. Second, whether or not a shareholder suit ever comes to trial, the escalating size of the pretrial settlements - like those of the banks in Enron and WorldCom - threatens to eat up the accounting firms' total capital.

In other words, an incremental addition of small-scale insurance is a proposed solution for the wrong problem. It's the mega-cases, the ones threatening to kill the Big Four, that are running amok through the current legal system and its puny arsenal of defenses.

Would the insurers want to play?

The popular perception is that insurance capital is a rainbow pot of infinite size. The truth is that the role of insurance as a risk-spreading intermediary is constrained by competing demands on its limited capacity. The insurers, burned by a generation of bad experience, have already looked at the auditors' exposure and are devoting their resources to more predictably quantifiable disasters - like hurricanes and airplane crashes.

Audits of real value to investors can be done - but only with realistic and achievable standards, at higher cost, and with tolerable liability limits. The chances of getting there, with the engagement of all the necessary players, may be as unlikely as an invasion of aliens. The process has just begun.

Independent Auditors' Reports -- If They're Obsolete, What's the Alternative?

On March 27 I posted an earlier column from the IHT -- here -- which suggested that the concept of auditor independence is providing no value to either auditors or users of financial information, but is worthy only to be scrapped. The follow-up column summarized broad reader concurrence, and opened the question what should replace the now-obsolete one page report.

Auditing on the Brink

Originally published in the International Herald Tribune on April 8, 2006

I recently put forth the argument that, because of the doubtful prospects for survival of the global accounting firms, the rules of auditor independence should be scrapped and the auditors freed to solicit whatever business they liked.

I expected to be treated as if I had impugned the combined athletic divinity of Pelé, Joe DiMaggio and Tiger Woods. But no, the responses were both positive and supportive. From a reader in Belgium, "Auditor independence is not only killing knowledge, it is killing business." From France, "Leaving ethics to the auditors' conscience should suffice."

To go the next step, a comment from Britain - "the key issues are the integrity of the auditor and the transparency and completeness of the audit conclusions" - pairs up with the poignant view of a retired partner in a Big Four global accounting firm that the code, rules and constraints of independence are worth preserving as "the very essence of what the auditors are selling."

But these views lie at the heart of the problem, which is the dirty little secret of the auditing game: The auditors' core product - the one- page report with its opinion that financial statements are fairly stated and free of material error - is providing no value to investors or other users. No one reads it or pays attention to it. If not for the deeply embedded compliance requirements of the securities regulators, no rational chief financial officer would engage outside auditors to produce it.

The presumptive value of the independent audit report, which has come down to us from the Victorian era, has been one of those Jeffersonian verities - manifest, unexamined and immune from critical challenge. But the evidence of its irrelevance is compelling.

The most sophisticated investors have long since stopped relying on audit reports. This is shown by the fact that, in the past 20 years, no lawsuits against auditors have been brought by the really smart guys - the venture capitalists, the managers of private equity or the financiers of leveraged recapitalizations. These users look at the cover of an annual report, yawn, and go about their real diligence.

Less sophisticated investors also ignore auditor reports, as shown by the complete disconnection, during the bubble years of the 1990s, between share values and audited financial results. Soaring share prices were supported by neither assets nor earnings under generally accepted accounting principles - nor, in time, even by revenue. The analysts herded their clients, and each other, down roads paved with airy business plans, empty promises and inflated expectations. At the point of collapse, the audit report provided only a ticket to the courthouse.

That audit work of real value could be delivered to users who would be prepared to pay handsomely is a proposition that deserves to be tested.

Here, off the top of my head, are examples of special audit reports that a savvy post-Enron chief financial officer would commission:

Focused attention, after Shell, on the procedures for evaluating petroleum reserves and the results of that evaluation.

Line-by-line scrutiny, after Parmalat and Bawag PSK, on the operations of Cayman Islands subsidiaries and Caribbean trading partners.

Detailed portfolio scrutiny, after Fannie Mae and American International Group, on complex financial instruments like derivatives and finite insurance.

Investment banks and investors in search of best-in-class assurance would line up for such information, and on contract terms that would eliminate ruinous auditor liability. And they would not give a tinker's damn for auditor independence. Their focus, and expectation, would be top qualifications and good-faith performance.

But not today. The combination of ossified compliance requirements, obsolete practice restrictions and runaway liability mean that auditors today could not sell such products even if they wanted to.

Those who pine for the days when an auditor earned broad professional respect by detailed examinations of the distinct items in corporate accounts are entitled to mourn. What they cannot avoid, however, even through the best-intentioned sentimental wishes, is the inevitable evolution that has taken the profession to the brink.

Valuable forms of financial statement assurance remain to be created and brought to market. What form the profession will take that will do so remains a vital question. The only certainty is that the structure will be different from the one that exists today.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Auditor Independence -- If There's No Value, What's the Point?

The latest example of finger-pointing in the credit market turmoil is the examiner’s report placing blame for the bankruptcy of subprime mortgage lender New Century Financial upon its auditor, KPMG. Released yesterday, and available here, the report echoes the drubbing that fell upon Andersen over Enron – a no-win subject for the auditors: “By which are you more corrupted – your breadth of client relationships, or your fee levels in general?”      

Public discussion is finally beginning to focus on the reality that the familiar model for auditor assurance on large-company financial statements is flawed to the point of requiring fundamental re-structuring. Especially in the absence of coherent and achievable solutions, however, one element deserving attention is the obsolete and over-valued concept of auditor independence.

So this column, originally published in the International Herald Tribune on March 24, 2006, retains its relevance.

Setting Free the Auditors

The American writer Dorothy Parker, who never shied from afflicting the comfortable, put it this way: "If you can't say something nice, come over and sit by me."

Parker would have been aghast at the self-congratulatory atmosphere among the regulators of the world's securities markets. According to them, the problem of dubious corporate accounting has been solved by strictly limiting the kinds of services the auditors can provide to clients.

There is nothing more sacred in auditor-client literature than the notion of auditor independence, which dates from the founding of the profession in the 19th century.

Yet with auditors today stumbling under the weight of litigation - each of the surviving Big Four accounting firms having a list of cases large enough to be fatal - this unexamined burden has become yet another millstone. And a proposed solution circulating in the halls of Washington - involving a waiver of the Sarbanes- Oxley rules limiting the scope of auditor services to clients - is a political nonstarter.

So I say it is time to stop making nice and to discard a 150-year-old piece of conventional wisdom. The concept of auditor independence does not serve the interests of investors.

Audit performance - and more immediately, the survival of the large firms to serve their global clients and the capital markets - would be better achieved if the current independence requirements and constraints were scrapped altogether.

Auditors should be free to provide their clients with any services within their skills. The only thing that should be required is comprehensive disclosure of all relationships, to be evaluated and decided by the voting power of the marketplace.

Some will be scandalized by the suggestion that the sacred cow of auditor independence should be led off and humanely put out of its misery. But there's a reason it should be done.

Regulators confess to being clueless about what will happen when the next of the Big Four accounting networks disintegrates under the combined pressures of hostile law enforcement and overwhelming shareholder litigation. (Think it can't happen? After Enron and Arthur Andersen - and the $456 million fine over questionable tax shelters paid by KPMG to escape indictment? It's Russian roulette out there, and the gun is full of bullets.)

The purest argument for driving the profession back to audit-only basics has always been that as clients pay the fees, for services of any type, auditor independence is inevitably subject to compromise.

But to finish that thought, in a system so inherently subject to corruption, auditors should never take any fees from their clients. So who will pay? Inserting a government-run fee and license structure amounts to nationalizing the audit function - an idea that figures nowhere in rational dialogue. And there are no other volunteers around.

Likewise, the argument that consulting fees corrupted auditor behavior was always a bit stretched. Heady as that stream of revenue was, it was the money itself, not the source. It could be said, in fact, that auditors who depend on audit fees alone are under even more pressure to accommodate client wishes. And whenever that accommodation has turned ugly - Andersen's travails with Enron being only the most egregious example - it's the firms that pay. As recent history shows, they have neither the reputation nor the capital to bear the terrible cost.

Clearly, the accountants garner neither respect nor liability protection by complying with these enforced codes of independence. They, and their clients, would deliver better value if audits were based on a comprehensive understanding of and involvement with the business. In other words, auditors need to be closer to their clients, not farther away.

Who better to ensure that financial statements are free of error than a professional who designs, installs, operates and maintains the system that accounts for the transactions of an enterprise - the very services from which today's auditors are barred?

This does not dismiss the importance of accountability or of oversight. Regulators have their place - but only under systems of liability that address the reality of today's deadly threats.

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.

Accounting and Audit Judgments -- Please, No More Standards!

A new one-liner in the cultural vocabulary was introduced when the hit comedy, “No Sex Please, We’re British,” opened in London in 1971.

Today’s plea – with the Securities and Exchange Commission’s proposal to inflict an analytic structure upon the making of accounting and audit judgments – would be “No Standards Please, We’re American.”

On February 14 the SEC presented for public comments the interim progress report of its Advisory Committee on Improvements to Financial Reporting – here – which among its suggestions was that the Commission should adopt a “judgment framework” in the accounting area, and that the country’s audit regulator, the Public Company Accounting Oversight Board, should do the same for audit judgments.

Responses to the SEC are due the end of this month. Meanwhile, the PCAOB sponsored a panel discussion on February 27 by its Standing Advisory Group – summarized here by Edith Orenstein of Financial Executives International.

The signal achievement of this day-long effort was that the competing interests in the debate managed at the same time to expose both the hazards and the vacuity of the whole idea.

As co-presented to the PCAOB group by a managing director of Moody’s – yes, the credit rating agency – the notion is this:

•    Preparers of financial statements would be assisted by yet more pages of codified bullet points, in choosing and applying among the myriad of alternatives for selecting and implementing accounting standards, quantifying estimates, evaluating evidence and all the rest.

•    Auditors, likewise, would be similarly enlightened across the spectrum of judgments required to choose audit procedures, to evaluate the likelihood and impact of fraud and other risks, to conduct audit sampling, to evaluate controls and – layering the irony – to assess management’s own judgments.

Wait.

In the century and a half since the emergence of independent accounting early in the Victorian era, preparers of financial statements and their auditors have been striving get their judgment processes right. So who are these bureaucrats, with their presumption of assistance?

This is, after all, the same SEC that was caught flat-footed over the pervasive extent of executive options back-dating. The same PCAOB that in its sixth year has no more than a pilot program for constructive engagement with non-US regulators and inspection beyond the samples taken within its own borders. And the same Moody’s whose involvement in the subprime mortgage fiasco, along with the other major credit ratings agencies, finds them to be central in the still-spreading credit markets turmoil.

Put another way, taking advice on the process for judgment-making from this crowd could be viewed like hiring Noah to give flood-control advice to the city of New Orleans.

As for the parody that passes for debate, the self-interested and antagonistic participants are circling the topic and each other like stray and wary dogs around a hydrant.

The accounting firms at the PCAOB’s table gave cautious endorsement to the framework idea, despite the obvious hazard: By getting it right they would obtain no more credit, safeguard or protection than is available today under existing guidance. Instead, they would only have one more procedure to get wrong, and therefore increase their already debilitating litigation exposure.

The large accounting firms remain muzzled on their fragile and threatened state, unwilling out of either fear or denial to acknowledge the shockingly low litigation impact that would cause their disintegration (which I've calculated and discussed here).

As a result, they are inhibited from insisting that the only realistic usefulness of yet more regulation on the exercise of their judgments would be under a “safe harbor” within which they could explore and apply new modes of working.

But on the other hand, investor advocates among the profession’s critics make plain the political reality that no adjustments in the American legal liability framework that entraps the auditors today are about to be forthcoming.

Exposing the sterility of the discussion, even the regulators themselves are in full self-protection mode, making clear that nothing in the application of the suggested framework process would inhibit the SEC or the PCAOB from examining and criticizing the judgments made by issuers or auditors.

For British theatre-goers the farce of “No Sex Please” ended when the nightly curtain came down. Because a new "judgment framework" would offer benefits that range from elusive to non-existent, would impose costs of extra work and documentation that are extensive, and would inflict potential litigation hazards that are considerable, the farce now playing out in Washington deserves a closing notice.   

For other aspects of the PCAOB’s meeting last week, see my friend Francine McKenna at Re:The Auditors -- here.

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

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

The Impact of Unheard Bullets 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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