Re:Balance -- Jim Peterson

Medical Check-Ups and Annual Audits: What if Your Doctor Reported Like Your Accountant?

Now being the winter of our discontent, the political scene in American is dominated by the rancorous wrangling over health care and insurance reform legislation.

In that context, I was exchanging notes with my friend the insurance industry risk-manager, over our recent annual physicals, and fell to musing about the comparability of a financial statement audit and a personal physician’s examination.  

Raise the question of personal health around a table of the reasonably responsible. The “organ recitals” of those surveyed will include familiarity with their own particular concerns – whether blood pressure, good and bad cholesterol levels, resting pulse, bone density, or hormone levels.

To achieve that awareness, on a periodic and routine basis, patients are poked and prodded and invaded in various intrusive and unpleasant ways – they give up samples of fluids and tissue for laboratory scrutiny, and they are screened and hitched and wired to exotic and expensive diagnostic machinery

The population of the diligent will also be subjected to inquiry by their doctors about their major behavioral risks – does their personal “control structure” include taking their medications, watching their cocktail intake, wearing their seatbelts, and avoiding handguns.

And then they receive several pages of detailed results, calibrated to standard norms of tolerance, and a briefing on what their trends are and what they might need in aide of maintaining or improving their well being.

Suppose instead, along with a bill whose magnitude is itself a threat to good health, the physician delivers this report:

“We’ve done a number of tests, the scope and results of which you don’t have, and we chose not to do a number of other, unspecified procedures.

“We’re not sure, but we think you’re unlikely to die of natural causes any time soon.

“Thanks -- we’ll see you next year. Be sure to pay on the way out. And have a nice day.”

Unacceptable – even with the multiple dysfunctionalities that render American health care an embarrassment among the world’s developed countries.

Does an audit report convey anything more about the health of a corporate body?

A company’s management may be well informed or sclerotic. Its products and strategies may be world-class, or senescent. It may be the equivalent of a gold-medal athlete, but with a malign and life-threatening growth lurking or metastasized. 

But the only available opinion is that, within the tolerance of undisclosed measures of materiality, its financial health is generally fair.

Does the company need the corporate equivalent of a slimming regime of diet and exercise? Are prescriptions indicated to bring the basic operational chemistry within tolerable limits? Something surgically targeted like joint replacement or a major arterial by-pass? Radical intervention or experimental drugs?

At the cost of millions of dollars, no such diagnosis is on offer – but only a single anodyne page, in the same language handed out once a year to every other patient who passes through the annual audit clinic.

An auditor’s report tells less about a public company’s health than a doctor’s report tells about an individual – in scope, detail and precision. And if investors and other financial information users are not happy, they are doing nothing to make their dissatisfactions effectively known.

It may be, as Mary Poppins puts it, that “a spoonful of sugar makes the medicine go down.” But in the audit environment, patients are getting only sweets and placebos – and still paying for the dubious privilege.

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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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On the Midwestern Calendar for March: Two Events Addressing the Audit Profession

An alert for those in the Midwest looking to warm up the chill of late winter: I am looking forward with enthusiasm to joining Duane Kullberg, retired managing partner of Arthur Andersen, who will be the Chapman Executive-in-Residence at Carthage College in Kenosha, Wisconsin, on March 2 and 3.

 On Tuesday evening the 2^nd, Duane and I will be on a panel on the “Future of the Audit Profession,” joined by Bill Goodman, CPA and president of Schenck Business Solutions and chaired by Dennis Tomorsky, CEO of the Wisconsin Institute of CPAs. At the college’s Todd Wehr Center, 7.30 pm.

 On Wednesday the 3^rd, the Kenosha/Racine area Business and Professional Coalition’s regular luncheon will feature Duane’s presentation and our taking questions on the “Rise and Fall of Arthur Andersen.”  Noon, also at the Todd Wehr Center.

 Any further details will be forthcoming, so drop me a line to be advised, or are available through David Brunn, Carthage’s Rogers Palmer Professor of Business Administration (tel: 847-256-2287 or e-mail: dbrunn@Carthage.edu).

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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Sheep Dogs and Stewardship -- Why Groom the Next Generation?

Reader reaction indicates that I touched a sensitive subject, when I suggested on November 10 – here – that there was a mis-alignment in the compensation models of the large accounting firms, who distribute immediate profits to their current partners while the potentially devastating impact of related litigation takes years to befall the succeeding generations.

Which suggests the broader personnel picture and the range of attitudes and strategies involved in obtaining, maintaining and retaining the staff necessary for an enterprise to thrive and survive.

Among the large accounting firms, the topic of cut-backs, lay-offs and treatment of subordinates is under-reported but acutely felt – scrutinized by the bloggers and their exploding audiences (see Re:TheAuditors and Going Concern), if mainly ignored by the mainstream media.  

As a way to measure corporate management’s behavior in the areas of governance, incentives and sustainability, consider a couple I know well, who in their “retirement“ are ranchers in southwestern Oregon. They tend the largest flock of Soay sheep in America – one of the oldest domesticated breeds known to human history – for which they have the indispensable aid of one spry border collie and a quartet of massive Anatolian sheep dogs.

This fall, as they do every other year, they made a two-day round trip to fetch a new puppy from their specialized breeder – bringing home an already formidable bundle of energy, who will quickly grow to 125 pounds and demand enormous quantities of both food and training. 

With a quarter-ton of canine appetites already deployed around their pastures, why do they add this burden to their back-bending task of hauling dog food by the truckload of hundred-weight sacks?

Because eagles and coyotes find special allure in the scent of baby lambs, and predators are kept at bay only by the imposing presence of a four-footed guard force on 24/7 postings at their fences.

The demands on the recruiting directors of the banks and law firms and accountants are not different. They manage their personnel pipelines because, as a senior Big Four partner put it in a moment of candor, “the only reason we hire new staff is so we can re-stock our need for managers.”

There is a crucial difference. An Anatolian has an average ten-year life span. And when the inevitabilities of age or accident claim one of their veterans, the ranchers cannot just drop into the nearest Pups-R-Us and charge a replacement to their Amex card. “Staff maintenance” is not just a slogan, when safe-guarding the inventory is quite literally a matter of life and death. 

But whereas it takes about the same length of time to train a sheep dog as it does to convert a university graduate into a decent staff accountant or associate lawyer, there are a whole lot more of the latter on supply, and the sources are numerous and diverse.

I’ve largely been of the view that the world’s anxious regulators should resist intrusion into corporate hiring and compensation structures – there being almost nothing in fragile and volatile business environments that cannot be further distorted or broken by the tinkering of an over-eager bureaucrat.

But all interested parties – employees and shareholders and, yes, the public overseers of taxpayers’ bail-out funds – should at least evaluate whether a company’s bonus arrangements and staffing strategies extend over the length of a business cycle or are focused only on this year or this quarter.

How else could anyone assess the credibility of pious recitals about the importance of preserving and maintaining morale, tenure and talent? 

So it is not a cynical observation that – unlike the coddled shepherd puppy whose specialization makes him uniquely difficult to replace – rookies in the professional services firms should both sign up and stay on with the open-eyed expectation that their tenure is likely to be limited.

A strategic suggestion for the realistic perspective of both new hires and young partners at the large firms, then, is that all concerned should investigate and share a common understanding -- whether promotion and retention prospects and decisions will be made over time spans of the length used by a careful shepherd.

Well and good, if so.

And if not, there are always greener pastures.

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On the Calendar: What Every Auditor Should Know About Litigation

The fall speeds on, and the calendar is packed. I am looking forward with enthusiasm to being at Baruch College in New York on Wednesday, December 2, for the Robert Zicklin Center for Corporate Integrity's 4th Annual Audit Conference, "Ensuring Integrity."

Information on the agenda and registration is here. It will be an interesting day, led by Professor Doug Carmichael and including senior staff members of the SEC and the PCAOB as well as representatives of the large firms.

I will be on the last panel of the day -- deliberately scheduled, I suspect, so as not to put anyone off their lunch -- "What Every Auditor Should Know About Litigation." Professor Carmichael will moderate, and I will be joined by Jim Sabella of the hot plaintiffs-oriented law firm of Grant & Eisenhofer, and Willkie Farr & Gallagher partner Mike Young, probably the accounting profession's best-known adviser/spokesman.

The content for our panel will be under development in the next few weeks. I have some ideas of my own -- but I invite you to write with your thoughts. What would you like to have addressed? On what litigation topics should auditors know more -- or other than -- they do now? For that matter, to bend the topic a bit, what should other constituencies know about auditor litigation.

I'll welcome and take up your suggestions -- and will report back later with more to say.

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Global Convergence of Accounting Standards? In Whose Lifetime?

A senior member of the fraternity of pundits touchingly spoke, recently, about one effect of the passage of time: “The older I get,” he said, “the more care and respect I have for the phrase “not in my lifetime…’.”

There’s a grain of sense -- however frustrating it is, that decent respect for the elderly means that we have to pay attention to the superannuated, however unwilling they are to surrender their microphones. Truth to tell, there is usually an inverse relationship between advancing age and advanced intelligence -- examples would be gratuitous but readily available on request – suggesting a requirement that pontificators come with staleness warnings or prominent display of a sell-by date.

That said, there is a recent media flurry around the long-dated estimate for convergence to a single set of global accounting standards – centering on the dialog between the Financial Accounting Standards Board in the United States, responsible for GAAP in that country, and the International Accounting Standards Board, responsible for IFRS as now mandated in the European Union and adopted to varying degrees in 100+ countries around the world.

The recent G-20 meeting in Pittsburgh was the context for a leaders’ statement by the great and the good, calling for completion of a convergence project in 2011 – a date also targeted for the US SEC’s decision to require IFRS adoption (for a helpful review of the state of play, see Edith Orenstein’s FEI Blog.)

Meanwhile in furtherance of the accounting profession’s party line, Ernst & Young’s global chief Jim Turley is quoted (in the Going Concern blog), flogging a single set of standards as “imperative.”

The chorus for convergence is not singing in unison. No critic is more trenchant or persistent than Tom Selling (The Accounting Onion) – although in an era of commentators’ ranting for ratings, sound reasoning and intellectual rigor have limited weight.

It matters much more that the reluctant Europeans will likely have their way. The Financial Times reports – here – that Henri de Castries, chief of French insurance giant AXA, views the setting of standards as “a matter of political sovereignty” and that French finance minister Christine Lagarde has put it to EU financial services commissioner Charlie McCreevy to “’ensure the safeguard’ of European public interest.”

Which sounds entirely like dressed-up cover for another version of the European capacity for protracted refusal to yield up national autonomy – foreshadowing a de facto continuation of country-based “mark to management” accounting, however pious the leaders’ pronouncements in favor of convergence.

Not that it may matter all that much, in a financial reporting world where comprehension and comparability are already elusive.

A generation ago, one of my then-colleagues – the world’s expert on accounting for complex financial instruments – maintained a list, on which he always included one entirely fictitious product. His standard wager of a full year’s bonus was that even a knowledgeable practitioner would not find the bogus item – and he never found a taker.

In practice today, he would say that there is already so much slack, judgment and overnight obsolescence in the tough issues of recording and reporting, even within single systems – whether the best-in-class among the major countries’ local GAAP or under IFRS itself – that the prospects for true convergence at any level of detail will remain perpetually elusive.

Add in the politically-motivated local vetoes being retained by the likes of the recalcitrant French, exemplified by the spirit of M de Castries and reflected in the measurements of European progress over spans of geological time: the deeply-embedded antagonisms and resistance recall the lesson from high-school geometry, that parallel lines only converge at infinity.

If only for these purposes, how delicious it would be if Ernst & Young were AXA’s auditors in France. Armed with the opposing attitudes of their bosses, if the client’s chief financial officer and the audit engagement partner were put to a debate on convergence, which one would emerge alive?   

One thing for sure – considering that the footnote in AXA’s 2008 annual report that sets out its choices and description of accounting principles already runs to sixteen pages (here): for anyone tempted to estimate a future date on which AXA might issue financial statements under a single converged set of globally-applicable accounting standards, it would be a safe bet to go with “not in our lifetime.”

 

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The Big Four Accountants and the Specter Bill to Reverse "Stoneridge": Please Don't Throw Me in that Briar Patch!

Because “dumbed down” education is a poor trade-off for political correctness, it is unfortunate that the Uncle Remus stories no longer flow through children’s literature into popular culture.

A favorite from my childhood involved the wily Br’er Rabbit, who was caught up by Br’er Fox’s tar baby, but duped his nemesis by imploring, “Please, don’t throw me in that briar patch.”

Even though my father’s rural twang made strange work of the concocted plantation dialect of Joel Chandler Harris and his 1880’s adaptation of African-American folktales, the didactic moral in the rabbit’s witty strategy was clear – the briar patch was where escape and safety lay.

It’s the same today for the large accounting firms in the United States, who confront a dilemma in the legislation proposed by Senator Arlen Specter (D-Pa.) to overturn the January 2008 decision of the Supreme Court in the Stoneridge case (here), so as to broaden and extend civil liability claims against gate-keepers and other secondary actors for violation of the American securities laws. (For a very nice and concise summary, see Kevin LaCroix’s D&O Diary.) 

The auditors’ position is particular. Despite blizzards of careless commentary, their litigation risk in the classic big-ticket shareholder actions was unaffected by Stoneridge, since the public availability of their reports distinguished them from the equally essential but backroom roles of the bankers and the lawyers -- for whom the Specter proposal offers a clear and present threat of massive new liability.

So the lobbying will be focused and furious. But like Br’er Rabbit, if the auditors are well advised they will recognize the opportunity that lies in amendments suggested by Columbia Law Professor John Coffee (here) – offering the auditors a briar patch within which they might at last find relief for their threatened survival.

As a bone to the considerable influence of the lobbies of potential new defendants, Br’er Coffee suggests liability limits for secondary actors – a concept that for the auditors is essential (if not sufficient – see here) if they are to attain survivability in the face of their over-hanging and potentially ruinous litigation exposures.

Not that Professor Coffee has his dollar formula remotely within politically achievable limits. With the recent generation of schemes and corporate failures measuring well into the hundreds of billions, investor representatives will rail that damage ceilings of $ 2 million for individuals and $50 million for corporations are off by at least two orders of magnitude. 

Coffee does go on to suggest a “wealth ceiling” of ten percent of income, net worth or market capitalization. This is a test that the Big Four accounting firms could survive – if based on the $ 10 billion that is the roughly-averaged 2008 income of their practices in the US-dominated American region. (And interestingly, a $ 1 billion damages ceiling for US exposure would also be consistent with Big Four survivability under research done for the European Commission – here. ) 

Could the Big Four persuade Br’er Specter to throw them into that liability patch? Several reasons would indicate skepticism:

There is the challenge of vision. Leadership of the profession has been notoriously squeamish, and several vials short of the testosterone level needed to propel them forward in support of a holistic legislative program for their own survival.

Further, the complex political calculus in Washington suggests that the administration of President Barack Obama will toss something to its left side. If so, lobbying dexterity will be tested to the extreme to insert and maintain liability limits into the Specter plan. In this process the accountants will need to align forces with the other gate-keepers – a logical if historically rare occurrence.

Put another way, there is the simple matter of legislative effectiveness, at which the accounting profession’s dismal track record is perhaps best cited to the description given by Crash Davis (Kevin Costner) in the 1988 baseball classic, Bull Durham: “Couldn’t hit water if they fell out of the (freaking) boat.”  

Inaction and passivity will leave the large firms where they are -- stuck to the tar baby of their litigation exposure. Initiative, subtlety and cunning may not be in long supply, on the other hand – but in the animal kingdom of Washington, they offer a best hope.

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The Weekend Press: "Billion-dollar Lawsuit Could Destroy Top Accountancy Firms"

The Finance section of this Sunday's edition of the London Telegraph carried a piece by Sean Farrell, under the evocative and self-explanatory headline, "Billion-Dollar Lawsuit Could Destroy Top Accountancy Firms."

It can happen. Attention should be paid.

Farrell captures the essence of the structural weakness of the current model for the delivery of audit services to the world's large global companies, as demonstrated by the speed with which the Andersen firm disintegrated in 2002 under the stress of the Enron debacle:

"Andersen's collapse highlighted the fragility of a global accountancy partnership. As soon as the extent of the fraud was made public, Andersen's international divisions and partners not involved in the scandal detached themselves from the firm, making it impossible for Andersen to survive. The nightmare scenario for the big four – PwC, KPMG, Deloitte and Ernst & Young – is to be caught out by the next Enron." 

I talked at length with Farrell last week, while his story was in preparation -- and was gratified to see his uptake on the under-appreciated research done on the limited financial capacity of the Big Four to resist or withstand large-scale litigation claims, because as private partnerships they lack access to the outside investor capital available to public-company corporate structures:

"A London Economics study for the European Commission three years ago calculated that the biggest claim a London arm of a big firm could bear after the exhaustion of insurance was €540m (£474m). The report says: 'As firms have practically no assets of their own which could be mobilised, the partners of the firm would in such a case bear the cost of the adjustment. At issue is the size of the financial burden that partners would be willing to bear before the firm collapses'."

I've written on this subject before. See here and here for calculations of the "tipping point" numbers on the Big Four's exposure to litigation in the US -- where the largest threats are lurking -- numbers that should be eye-opening because they are miniscule compared to the firms' exposures. 

Farrell quotes me:

"(A)ccountants already face pressures from incoherent international accounting standards, huge potential litigation liabilities and their own failure to meet the standards expected of them. He says on top of these recurring problems firms now face mounting litigation connected with Madoff.

"Peterson says: 'What is not generally appreciated is that most accounting firms work with a level of capitalisation supplied by their partners that is woefully thin... There is no big four firm that could survive a judgment as high as $2bn'.

"He argues the fall of one more big four firm could cause the system to collapse because rules on conflicts and the big four's patchy geographic strength would prevent the remaining firms from mopping up the business as happened after Andersen's blow-up."

Critics of the accounting profession will have their say, as they well should. But no discussion agenda on the future of the large-company audit franchise is either complete or credible unless it includes the unsustainable nature of the current regulatory and legal structure, within which the business model of the Big Four firms is at mortal risk.

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Forecasting the Survival of the Big Four: Does a Black Box Model Hold the Answer?

If the global tumult of the last two years has taught us nothing else, it’s that reliable forecasts on complex issues are damnably hard to come by.

So where can wisdom be found today, on the vexed and pressing question of the survivability of the Big Four accounting firms and their franchise to audit the world’s large companies? Arrayed in an existential threat are the aggregated forces of unachievable performance expectations, unrelenting regulatory hostility and devastating litigation exposure – against which, what are their chances?

The question about the presumptively available but failed sources of advice and prognostication is not whether the recent performance of model-builders and risk managers has failed to provide actionable guidance – plainly it has not, as credit markets seized up and venerable institutions toppled -- but how extensive were their own contribution and culpability.

A possible source came on the screen last week. Clive Thompson’s article in the New York Times magazine for August 16, “Can Game Theory Predict When Iran Will Get the Bomb?” features the “black box” prediction methodology of a New York University professor and Hoover Institution fellow. Bruce Buena de Mesquita’s forecasts on the complex interactions of variously influential parties are applied in contexts ranging from the business strategies of large companies to geopolitical hot spots for the Central Intelligence Agency.

Bruce’s method starts with identification of those with interests – whether the conflicting constituencies in the ever-shifting landscape of Iranian politics, or the negotiating partners in a potential corporate merger. He assigns values to their respective goals, commitments and capacity for influence – numeric inputs which are then processed by his proprietary (and opaque) computer model in an iterative series of scenarios, eventually leading to a conclusion as to the outcome.

Here’s the thought: an identifiable set of inter-locking antagonists are now in mutually-reinforcing paralysis on the fate of the large accounting firms – each with deeply committed self-interests being served, and all suffering limitations of vision and authority:

That roster includes -- along with the issuers of financial information and their auditors themselves -- the banks, investors and other users; the professional standard-setters, regulators and politicians; and the several-faceted machinery of law enforcement including prosecutors, judges and lawyers – as well as, probably for completeness, the communities of academics, critics and other observers.

Bruce’s techniques of inputting stakeholder interviews into a multi-scenario decision algorithm yield predictions that are valued and used at the level of global intelligence agencies, regarding issues on the scale of nuclear deterrence policy or the evolving role of the BRIC economies. So he should find it a piece of cake to crank up a view on a question as straightforward as whether the Big Four and their one-page auditors’ report have a viable future.

Considering that the present models underlying the use of Value-at-Risk, dynamic hedging and complex derivatives valuations have been shown no more robust than old-fashioned consultations with the oracle at Delphi or the entrail-reading of a Roman haruspex – or for that matter, turning over today’s desk-top 8-Ball -- Bruce’s approach might well be of great value.

Or at least, shouldn’t somebody think it an undertaking worthy to be engaged and widely shared?

Let me know if you think so.

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How Valuable is Today's Audit Report? Military History's Metaphor for "Expensive, Obsolete and Irrelevant"

The dog days of summer. I’d rather be under a beach umbrella, doing teaching outlines for the fall semester with the facilitating aid of something cold and rum-based. Instead I am in deep dialog on tough issues with one of the world’s thoughtful accountancy regulators.

A very small group, that. “Thoughtful accountancy regulator” being as oxymoronic as “Italian justice system” or “effective Belgian government,” their entire convocation could be booked in a telephone booth with room to spare.

On our table was one of my persistent themes, under the rubric of the threatened survivability of the Big Four and their nearly exclusive franchise to audit large global companies – only one major shock away from disintegration, which once started will be unstoppable not least because of the limited vision and authority of the political and regulatory classes.

Namely, there is no real chance to get ahead of this destructive tidal wave without explicit confrontation of the obsolete and anachronistic nature of the audit report in its current form.

To this proposition, my correspondent suggests there is at least some chance of traction under cover of the legislative debates on the question why auditors did not do more in relation to the credit and banking crisis of the last two years.

Possibly. But because the lawmakers’ limited attention span is focused elsewhere – on executive pay schemes and bank survival subsidies and constraints on short sales and flash trading -- I doubt it.

Our exchange calls to mind a recent holiday, and the moving experience of touring one of the surviving fortresses of the Maginot Line – the defensive installations named for France’s Minister of Defense, built in the 1930’s and left largely unscathed when the invading Germans simply and speedily flew their planes and drove their tanks over and around.

Dug deep into the Alsatian hills, these brutal piles of 1920’s military technology – built for 3 billion francs and among the largest public projects in France since the construction of the Gothic cathedrals – are derided by history as a strategic failure, because they were rendered irrelevant by the German circumvention.

Yet consider the success -- in terms, the Line did its job. It was evaded, rather than destroyed by direct attack; surrendered largely whole, rather than bombarded; and only thereafter abandoned by government to the effects of rust, decay and amateur tourism.

It’s much the same for the modern-era audit report: Conceived in an earlier and simpler time, oriented to the avoidance of problems no longer meaningful, and now ignored by aggressors with superior tools in their armory. Consuming vast sums of defensive budgets, engaging battalions of trained and expensive manpower in an endeavor of questionable value, and achieving no obvious deterrence against threats on a scale of systemic corporate collapse.

Life for the French garrisons would have been misery: cramped underground in caves of steel and concrete; enclosed by machinery, ducts and wiring; ventilators struggling with the confluent mixture of petrol, dangerous explosives and close human quarters. Happily, except for times of drills and alerts, they were often able to emerge into the French forests, to hunt the birds and rabbits that relieved their military rations. 

Contrast the modern audit engagement team – inflicting vast costs on their clients for a marginal purpose, toiling away to tick the boxes required by Sarbanes/Oxley and its equivalents, facing a hostile world through the narrow visor of inflexible reporting requirements and a crude and outmoded arsenal of opinion language, and exposed to being out-flanked or over-run without warning by antagonists of superior mobility and strategic imagination.

Just as the Maginot Line proved its worth as a sublimely ironic success against invasion that never came, the current audit report stands as a bulwark effective only against the kind of assaults about which no one cares.

Instead, just as the hapless French troops were obliged to surrender without a struggle when overtaken from the rear, the modern system of assurance has been revealed as dug in and powerless against such invasive forces as the exotic financial derivatives of the credit crisis or the guerrilla tactics of a Bernie Madoff or an Alan Stanford.

And to what end? The metaphor can be pressed one step further. By surrendering the Maginot Line’s indefensible position, the French cut losses that would otherwise have been catastrophic, and survived to be joined by their allies in a strategic re-grouping.

As with supplanting the dimly mis-guided André Maginot, can the regulators find in their weary ranks the likes of a Churchill or Roosevelt or DeGaulle?

Cometh the hour, cometh the man? The future of the profession can only hope.  

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A Summer Lull for the Accountants? Sez Who?

We ought by rights to be in the summer doldrums – those still doing real jobs are taking a break in the country or at the beach, and the rest are hunkered down till the headhunters come back to town in the fall. But there’s a sudden flurry of attention and activity around the world of the large accounting firms.

And while human societies are good at generating coincidental events that don’t really add up to a pattern, a little reflection indicates some possible common threads:

Item: Joining the expanding list of observers giving scrutiny to the business models and exposures of the large audit firms, comes the launch of Breaking Media’s new blog, “Going Concern” – dedicated, says its introduction, to “making accounting sexy.”

Well, maybe. Many of the large firms’ wounds are indeed self-inflicted. Still, snarky tabloid gossip that trades on the displays of venality and shortness of leadership vision will not advance the search for solutions to the profession’s lessening relevance and doubtful survivability. The issues are too nuanced and multi-faceted for that.      

But if it is facile to deliver easy jabs, even the kings of lore and legend engaged their court fools, so that hard truths could be wrapped in the wisdom of a laugh or two.

So welcome to Caleb Newquist’s new effort. Godspeed, and let the dialog expand. 

Item: The incongruous conjoining of “sexy” and “auditor” in the same sentence does seem like an effort for the scriptwriters of Monty Python -- proved again by the publicity last week around the presentation by Audit Analytics, “Accounting Professional Liability: Scorecards and Commentary.”

Variously describing the large firms’ litigation exposures as “a serious and growing problem,” or more gravely as “a breathtaking number,” the data for the Big Four firms should be a splash of cold water to awaken on the gravity of their exposure threat -- but in fact have yet to reach the level of public consciousness sufficient to kick-start a serious debate on the threatened viability of the large firms’ basic assurance franchise.   

Not that life is any more pleasant beneath the Big Four level:

Item: Up in the normally understated Scandinavian territory of Minneapolis, the McGladrey Pullen firm’s attempt to extricate itself from its entangled business venture with H&R Block and the RSM network was promptly met with a retaliatory lawsuit (here).

Among the more subtle lessons learnable from the break-up of the Andersen organization and the departure of its consulting practice to become Accenture was the potential for the distraction of management time, focus and strategy.

In that case the cleavage between practices made for at least reasonable clarity in the allocation of personnel, systems, methodology and real estate. Whereas in the McGladrey/RSM context, by contrast, reverse-engineering their constituent practices into separate and discrete post-divorce portions will be a little like manufacturing tomato juice by starting with V-8.    

Item: On the BDO front, where the Seidman firm in the United States faces the survival challenge of the adverse jury verdict of $521 million in the Bankest matter in Miami (here), the network’s UK form, Stoy Hayward, announced last week its process for making redundant a full 10% of its partners (here).

Even in good times the strategy is fraught with peril of “shrinking to success.” And here, a decimation of the crowd whistling past the litigation graveyard might be thought to leave the survivors even a little more lonely and anxious. Although BDO’s international firm has been relieved of legal exposure to the Bankest verdict, it is hard to see how an organization in down-sizing mode is thereby made more robust against the business challenge of a devastating financial shock to its US firm.

Item: And back at the biggest firms, the announcements of shortened work weeks, employee furloughs and deferred job offers continue apace – hardly the brightest news for anyone concerned for the gold content of the litigation eggs sought for gathering by investor plaintiffs from the Big Four geese.

Much ink is being spilled in the search for trends and indicators in the profession’s lawsuit case count – noted above – but the exercise in fruitless and misleading. The profession itself has consistently mis-analyzed its fundamental risks, by taking the approach of “we dodged that bullet, and we still do lots of good work.”

The inductive flaw is basic: it’s not the average settlement amounts or the successful engagements that are deadly, or the close calls that are survived. So long as worst-case auditor exposures are measured in the billions of dollars, by legal and regulatory systems that pit unachievable standards against the firms’ inevitable lapses in performance quality, the Big Four and their smaller brethren as well will be hostage to the one last explosion that will start the final destructive chain reaction.

So let the media commentaries roll on. But let at least some of it treat serious issues with the gravity deserved. 

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OK -- It's Agreed: There's a Crisis in Audit. So When Do We Get Down To It?

The city-bred sportsman hires a local fishing guide, who promises great results as they anchor in a remote spot. From the tackle locker, the guide pulls out a stick of dynamite, lights it, and throws it over the side. A huge explosion, and dozens of stunned fish float to the surface. As the guide nets the fish, the tourist begins to rant about poor sportsmanship and illegality.

The guide calmly lights another stick of dynamite and hands it over. “Are you going to keep running your mouth?” he asks as the fuse sputters. “Or do some fishing?”

Readers here are well advised to invest an hour catching up with last Thursday’s webcast, “2009 Mid-Year Review – Securities Litigation and Enforcement” (archived and available here).

This edition of Bruce Carton’s valuable extensions of his vital news source, Securities Docket, assembled four of the bloggers on my must-read list – Lyle Roberts (10b-5 Daily), Tom Gorman (SEC Actions), Francine McKenna (Re:The Auditors) and Kevin LaCroix (D&O Diary).

It was barren times for the subject indeed, back in 2002 when the Paris newspaper launched my financial and accountancy column. But since then the family of commentators continues to grow, who contribute substantially to the consensus of crisis in the entangled relationships among issuers of financial statements, their auditors, and the hyena herd of regulators, politicians and hostile lawyers.

Along with those noted above: Edith Orenstein (FEI Blog), Dennis Howlett (AccManPro), Tom Selling (The Accounting Onion), and Broc Romanek (CorporateCounsel.net) – and, with apologies, some I’ve surely missed.

The webcast is useful, on a variety of relevant fact-gathering and predictions; so too all the other increased attention. But concerning the on-going threats to the survivability of the large-company audit function, the discussion has yet to go past voyeurism, scape-goating and finger-pointing.

Here it is, seven years since the collapse of Arthur Andersen and the infliction of the ill-considered Sarbanes/Oxley law and its malign effects -- and two years and counting into a financial markets crisis of epic proportions. And not a constructive word is heard on the shape of the future.

Calling the dis-honor roll of those accountable:

The large firms’ leaders are handcuffed to a business model that they are powerless to change, under the combined constraints of the securities compliance regimes and their own partners’ appetites for the status quo of short-term profits. 

Their most vocal critics, among the commentariat, bay the cry of the profession’s self-serving venality, without taking even a first step down the path to re-design an assurance system now presumed (but not proved) to be important or worth working to save. 

The noisiest and most enthusiastic reader comments, meanwhile, range unconstructively from the punitive (“let them fail” and “jail them all”) to the self-destructive (“break up the Big Four” and “up with the little firms”) to the wildly impractical (“mandatory rotation” and “let the government do audits”).

Traditional debate platforms are empty. Former Treasury Secretary Henry Paulson’s Advisory Committee dissolved into insignificance without a trace, a year ago, behind a thin veil of posturing and animosity. The PCAOB, successful at least in perpetuating its own existence, is dribbling on the conflagration with an eye-dropper. Business lobbyists and academics alike are pre-occupied elsewhere.

And with no sign of a politician or a regulator in Washington or London or Brussels having either the vision, the interest or the initiative to take a lead, neither are there any other jurisdictions having the maturity or the salience to provide any influence.

The requirements for a useful forum ought to be within the grasp of the expanding collective of New Media mavens.

Ground rules and administrative questions should be modest enough: on-site or virtually distributed – freely accessed or modestly moderated to minimize the bickering and partisanship – live and real-time or via postings and dialog threads – open only to the credentialized or anonymous – sponsored or subscription or wide open.

Here’s the challenge: If this dynamite stick explodes, it will sink the boat and all in it. So it’s time to fish.

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Future Directions for Accounting and Audit: Can Anyone Get There From Here?

   

Recall the frustrated Irish villager, trying to direct a befuddled tourist toward Dublin:

        “If I was to be going there, I wouldn’t be starting from here at all.”

Last week came the news that Mark Olson is resigning as chairman of the American audit regulator, the Public Company Accounting Review Board.

Timely of Olson. He paddles away from a leaking ship, likely to be scuttled next year by a predictable Supreme Court ruling that the agency’s basic authorization under Sarbanes/Oxley back in 2002 was constitutionally flawed.

Also: Paul Boyle is departing as chief executive of the Financial Reporting Council, the United Kingdom’s audit regulator. Charlie McCreevy’s time is shortening as EU Markets Commissioner, whence comes what passes in Brussels for guidance on the topic. And Mary Schapiro and her crew of SEC newbies are fully pre-occupied with agency rehabilitation.

Along with the turn-over in all these seats, Treasury Secretary Tim Geithner this week may propose a “council of regulators” whose inevitable internecine squabbling will dilute even further the alphabet soup of American financial oversight.

So this long-pending question takes on renewed freshness:

Where is the leadership with the focus, vision and stature to bring about the fundamental and necessary re-structuring of both financial reporting and the related assurance – existing models having proved so ineffectual in the global financial crisis?

For dismal context, all this shuffling comes while a death-watch gathers around the continuing Bankest trial in Miami. There, a looming $ 522 million liability threatens to drop the final curtain on both the Seidman firm and BDO, its global network – here – proof to come that the mantra of “too big to fail” has no application to the large private accounting networks.

The likely legislative reconstruction in 2010 of a freshly-authorized PCAOB will present a one-time opportunity to write on a blank page, especially if Seidman has by then been hauled off to the knackers' yard. But the prospects are grim for grown-up guidance or perspective.

Certainly not from government. William McDonough, Olson’s predecessor at the PCAOB, left office in 2005 with the candid if pessimistic concession that “None of us (regulators) has a clue what to do if one of the Big Four failed”-- here. Four years on, and no clues have been revealed -- nothing has changed.

And as discussed almost a year ago – see here and here -- the gathering of talent known as the Treasury Department’s Advisory Committee on the Auditing Profession, convened by then-secretary Henry Paulson, limped into oblivion -- without managing even to agree that privately-provided large-company audits faced a serious threat to survivability, much less offering any hint of a blueprint for an achievable future.

Nor are there signs of life in the Big Four executive suites, where a managing partner would be deposed by immediate revolt for daring to propose serious change to the current model, creaky and obsolete as it is.

And the lobbying muscles flexed by issuing companies, over such contentions as mark-to-market and GAAP/IFRS convergence, have shown their allegiance to the status quo – preferring diminished transparency and reduced user value as the trade-off for their own control and dominance over the reporting and standard-setting process. 

The essential elements of a functional financial information regulatory structure are in principle not so complex:

•    Sufficiency of input to the setting of accounting and reporting standards.

•    Licensing and oversight of the audit function by which assurance is delivered.

•    Investigative and enforcement resources for the level of detection, prevention and deterrence of irregularity that society is prepared to pay for.

•    Finally, a last-resort structure for investor protection to supplant a liability regime that has run beyond the limits of sustainability.

Unhappily, the incremental nature of government evolution – including the certainty that the first priority for any agency is its own self-renewal and perpetuation – means there is only one true blank page: if the slate were wiped clean by the collapse of the Big Four networks and their consequential elimination as the only available source for large-company audit delivery.

That highly disruptive scenario is not one that any reasonable participant in the dialog could want or wish for.

But how else, the ominous question remains hanging, is a guiding force to come forth – one to map a future reachable by intelligent public exploration, discourse, negotiation and agreement?

As in the Irish village, there is no choice but to start from here. 

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