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.

Federal Charters for Accounting Firms -- A Blank Page Approach

Six years on from the disintegration of the Arthur Andersen firm, the fragility of the last Big Four and their franchise to provide large-company audits attracts a discussion that is steadily louder – but not more productive.

The latest example of a collection of the wise, talking past each other, was the June 3 meeting of the US Treasury’s Advisory Committee on the Audit Profession, summarized on Edith Orenstein’ blog – here – and webcast here.

A reason the discourse is so barren is the circularity of the blame-mongering. Rather than recognize the interlocking web of entanglements, the focus is on the problems of “the other guys.” The list includes:

•    Issuers’ incentives to manipulate their results
•    Overly complex accounting standards
•    Persistently inadequate audit performance by a too-small oligopoly
•    Regulators with over-lapping but parochial interests
•    Liability standards that lack precision in practice or predictability in outcomes, and
•    The overhang of catastrophe-level litigation that would overwhelm the audit firms’ fragile capital structures.

If there is ever to be a comprehensive, holistic solution, a blank-page approach is essential. There is such a framework at hand – although it would require a clean, robust and full-blown debate and a fresh legislative mandate. What is lacking, but essential in the organizational and legislative discussion, is the broad buy-in and ready participation that might actually replace today’s antagonistic finger-pointing.

Namely, national-level “charters” or “public company audit licenses” – the naming is less important than the concept – could authorize and regulate newly organized and re-structured firms -- that would do the audits of all public companies.

Applied in the United States – a jurisdiction necessary for any worldwide solution -- a new system would be administered by the Securities and Exchange Commission and the Public Company Accounting Oversight Board, having as analogies the government oversight of American stock exchanges, credit rating agencies and broker-dealers.

Newly organized “public company audit licensees” could be in corporate form. They could be owned by existing accounting networks or other new market entrants. Their resources – personnel, methodologies and technology – could be internal, or out-sourced from the existing Big Four or from emergent niche competitors.

For quality and enforcement purposes, audit engagement personnel would be individually licensed along with their employers, in coordination between federal authorities and existing state regulations over education, examination and training.  

Minimum capital requirements could be set, geared to the firms’ turnover or the capitalization of their client list. Governance structures could include independent outside directors, and accountability of management to agency oversight – measures not presently achievable under the constraints of state regulation and the laws of partnership and bankruptcy.

Collateral benefits to federal “chartering” abound:

Because these SEC licensees would be “audit only” enterprises, the multiple overlapping restrictions on scope of services would be finessed, and the endless debate over independence and permissible ancillary services could at last be ended.

Associated non-audit entities – whether parent or affiliate companies – would be freed from independence and compliance requirements, able to evolve beyond the one-page statutory report that now looks so obsolete. Targeted assurance reports could be designed that users in the capital markets would actually value and pay for. Immediate examples ripe for attention would have been Shell’s petroleum reserving, the internal trading controls regime at Société Générale, and the black hole of inter-company money transfers at Parmalat.

In aide of enhanced competition and expanded auditor choice, segments of the public company market could be specifically identified to encourage new entrants – such as high-risk or technically specialized sectors (IPO’s, troubled companies and financial services come to mind) – whose audits could be segregated, underwritten and priced as now done with high-risk insureds.

Under the aegis of the licensees’ regulators, a privileged forum could be organized to scrutinize cases of accounting and audit insufficiency for lessons and areas for improvement – drawing for experience on the airline, engineering and medical models for the successful study of failure.

As to liability -- the elephant in the room – and taking at their word the investor advocates who would prefer improved information over the capricious and low-return litigation lottery: the investigation and prosecution of all auditor claims based on public company financial statements would be pre-empted into the hands of the supervising agency. A specialized tribunal of expert jurists would hear all cases, levying fines and sanctions against convicted wrongdoers, both firms and individuals.

Compensation for legitimately damaged investors would be determined through the agency process rather than the caprice of juries and settlements, and be funded through a system of fee schedules rather than the hazards of limited firm capital.

Modifications of existing regimes would include elimination of the tax code’s incentives to maximize distribution of current revenues, and a cut-off above which audit firms would not audit their own owner/investors.

And with firewalls of corporate organization and bankruptcy infrastructure in place to limit liability, the conditions for insurability could be brought once more into alignment with manageable litigation and enforcement risk.

With this array of stabilizing governance changes in place, the new structures could at last be attractive to outside capital, which would be needed by offerors of new services in order to fund the necessary research, personnel and technology.

Given the dead-end nature of the debate these last years, the bare bones of this proposal should include something to excite or insult nearly everyone – which could be a signal that it is broad enough to be worthy of pursuit.

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.

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.

Can the Accounting Regulators Picture a Future Without the Big Four?

Saying the Unthinkable

Published in the IHT on November 10, 2007

There's a deep-seated and superstitious refusal to name what we fear. Believing "Macbeth" to be unlucky, Shakespearean actors refer only to "the Scottish play." Harry Potter's fellow students of witchcraft and wizardry refer to the dread Lord Voldemort only by the euphemistic "He Who Must Not Be Named."

The trouble is, anxious evasion of a problem can help to bring it on.

Or so it is after the gloomy reaction in Britain to the report last month from the Financial Reporting Council on possible relief for the accounting profession (here).  Attention is now over to the United States, where wise heads are gathering, under the auspices of the U.S. Chamber of Commerce and the Treasury secretary, Henry Paulson Jr.

Despite the threat to the survival of the Big Four accounting firms, none of the players - not the Big Four leaders, regulators or politicians, or the community of financial information users - will say it straight out: The large auditors' business model is broken, and their risks are unsustainable. The next large-firm failure will take down the other Big Three as well, just as fast as Arthur Andersen crashed in 2002, leaving large companies unable to obtain the current form of audit report from any source.

And why is nobody willing to ask what life will be like after the Big Four?

For that, I had a long talk recently with a senior accountancy regulator, who acts in a large country vital to the global capital markets and the future of the auditors. We found ourselves agreeing on the unappreciated necessity to confront a Big Four collapse and on the essential impotence of regulators or politicians.

We also had complementary approaches to the possible form and look of post-collapse assurance: In his world, beefed-up internal audit departments would report, with as much independence as they can muster. Audit committees would review and endorse the internal audit reports. And outside auditors would assess and report on the sufficiency of the internal auditor's resources, competence and scope of work.

Importantly, this latter report - well within the audit profession's capabilities, thanks to the experience gained under the requirements of Sarbanes-Oxley - would not require the scope of resources or the cost models of the current large firms.

In my world of the future, company reporting would be done by finance directors, on the basis of work done by outside firms, engaged from among the local and industry-based practices that would emerge from the wreckage of the Big Four. These firms would target their audit procedures and report on specific company areas ripe for attention - like a complex treasury function, a portfolio of risky assets, a troubled company operation or a first-time product or process.

From these two models, merged together, would emerge new forms of reporting and assurance, testable in the capital marketplace for value and utility to users.

And how would this all work, in a post-Big Four world?

First, internal audit departments would readily attract qualified personnel, out of the rosters of the late large firms, at compensation packages attractive to experienced accountants who would prefer the stability of corporate life over the uncertain risk and reward of the current fragile partnerships.

Second, the niche practices that held together after the large practices split up would also thrive in a new competitive environment. Their offerings would include the accounting expertise on which large enterprises will continue to depend, the new reports on internal audit departments, and the specific industry and geography-based assurance that finance directors will outsource and sell onward to the financial community.

Restructuring the current staffing models of the large firms, after the disintegration of their networks, would take one single recruiting cycle. The newly emergent practices would then operate with leaner resources, reduced costs and a profitable revenue model no longer hostage to failed attempts at pricing for the risk of unbearable litigation.

Third, and the driver for the first two, none of this reporting would ever claim to be in compliance with today's liability-ridden securities regimes, whose reporting requirements would have fallen to ineffectual disarray along with the firms themselves.

Instead, reports would be issued under strict limitations of liability to companies and their book of shareholders - not to the investor community and exploitation by the plaintiffs' lawyers. Reporting auditors would neither have nor claim independence in its now outmoded form. A truly competitive environment for assurance solutions, valued on a market-led basis, would replace the model that today is past its time.

Whatever the fear of speaking the unthinkable about the next era of large-company assurance, it is now on the table. There is a broad-based symposium, waiting to be convened by a top global regulator, under the title, "The Future of Auditing After the Big Four." If the boy wizard Harry Potter could name, face and overcome his nemesis, a group of adults should be able to do no less.

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

Can Midsize Auditors be Turned into Big Ones?

Published in the International Herald Tribune on October 20, 2007

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

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

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

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

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

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

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

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

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

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

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

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

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

Auditor’s Report as Guaranty -- Is There Any Real Value There?

What value is delivered to investors and other users of financial information, in exchange for the fees paid to outside auditors? As today’s capital markets are evolving, can the assurance function of the large accounting firms survive survive the strains and retain any relevance?

The Law of Diminishing Returns

Originally published in the International Herald Tribune on December 2, 2006

The problem with children, the writer and social critic Fran Leibowitz has said, is that they are seldom in a position to lend you a truly interesting sum of money.

That, in fact, is the problem with a guaranty of any kind: It is worth no more than the resources standing behind it.

And, as is rapidly coming into focus for the world's large companies and their auditors, the problem with financial statement assurance is the fragility of the private accounting partnerships - whose resources, compared to the risks they undertake, are not material, much less truly interesting.

The dialog is developing on the need for corporate accounting and accountability to evolve well beyond backward-looking and useless quarterly and annual reports. The latest entry in the debate came from the U.S. Treasury secretary, Henry Paulson Jr., who, in a speech in New York on Nov. 20 (here) , offered none-too- subtle praise for Britain's "light-touch" approach to auditing standards and regulation, even while observing that the reduction of the large-company audit market to the surviving Big Four firms "may not be healthy."

In this great game, the accountants naturally see themselves as central players. But the imperiled state of the Big Four and their highly concentrated audit franchise is a problem of nontrivial proportion. And Paulson's question - "Is there enough competition?" - sidesteps a crucial issue: Do the Big Four have the wherewithal to stay in the game at all?

A comparison of the accountants' resources to the ostensible value of their opinions is one way to assess the basic question of who can and should provide the assurance of the future.

The value of reliance is capped by limits on a guarantor's resources. In the entire credit industry, exposures are linked to ability to pay: the maximum size of a home mortgage is measured by the collateral value of the house; credit card ceilings are tied to payment history; even casino markers are designed to be collected, by means legitimate or not.

The ability to deliver against expectations is questioned everywhere. Bail bonds require sureties. Stock traders have strict collars on their portfolio exposures. Insurance policies are written with defined risks and fixed limits.
Think beyond the business world. An athlete's pre-game swagger is immediately tested by the scoreboard. The power and protection of multinational diplomacy depend on the strength of the available military and economic forces. For proof, consider this: Nobody seeks a mutual defense pact or a trading partnership with Zimbabwe.
In London, a banker may say with some credibility that "my word is my bond," but as the movie mogul Sam Goldwyn also put it, "An oral contract isn't worth the paper it's printed on." Both, sadly, are true.

So what is an audit report really worth to global companies whose individual market capitalizations dwarf the resources of the auditors?

The revenues of the largest 25 companies in the Fortune 500 ranged last year from $55 billion for Dell to $370 billion at Exxon Mobil. A recent study now in the hands of the European internal markets and services commissioner, Charlie McGreevy (here) , estimates that the liability "tipping point" that would take down a Big Four firm in Britain ranges from €170 million, or $223 million, to €540 million - amounts that hardly register against either the size of the companies they audit or the damages that can arise from large claims overhanging the firms themselves.

Those modest amounts effectively limit the amount of "audit insurance" that a large company purchases to be in compliance with the securities regulations requiring statutory audits.

Given all this, wouldn't it be rational - not to say normal - for a finance director or chief information officer to think this way:

"What are we getting in exchange for our audit fee? A report that nobody reads or values, and insignificant protection in the event we suffer a large-scale financial or audit problem.
"Wouldn't it make more sense to ask our own people for assurance on the quality and integrity of our systems and reporting? They design, own and operate the systems, so they are the most informed and best positioned - unlike the auditors who perform only a sampling function anyway, and who are constrained by obsolete requirements of independence from immersing themselves deeply in those very systems.
"If only the regulators didn't require us to commission and pay for these low-limit, effectively worthless reports, couldn't we hire our accounting firms to design and perform work that both we and our investors and bankers would really value?"

Don't hold your breath.

No chief executive of a Big Four accounting firm could face his partners by admitting the acuity of those messages, and they lack the support in the capital markets to seize the initiative and re-design their business models.

But on their behalf, there is a clear message for regulators in Washington and Brussels and London. In a world of globalized capital flows, ready to migrate away from regulatory excess, it would be this business ultimatum:

Because the best a company can expect in a financial statement disaster is less than $1 billion of auditor support, the current system is not working. Unless it is fundamentally redesigned, the large companies will shortly declare it irrelevant and opt out.

On these issues, even Leibowitz would have echoed Groucho Marx: "A child of 5 would understand this. Send someone to fetch a child of 5."

The Accountants' Own Search to Establish Real Value

Accountants and Auditors: Time to Part Company?

Originally published in the International Herald Tribune on November 18, 2006

"Sell when you can. You are not for all markets." --
    Rosalind to Phebe, "As You Like It," Act III, Scene V

In advising a country girl to accept her suitor's offer, Shakespeare had it right: Seizing the opportunity to adapt a narrowly focused product or service to changed conditions is a challenge.

Especially these days for the global accounting firms. Last week the six largest global networks - the Big Four of Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers, joined by Grant Thornton and BDO - issued a joint report that finally brought into the open a theme long recognized but little discussed: the uselessness of the current financial reporting model.

As laid out in the report - snappily titled "Global Capital Markets and the Global Economy" and available here -- the traditional backward- looking "snapshot" of a quarterly or annual report is obsolete and requires replacement. It vaults into the 21st Century by proposing, among other things, an Internet-based system in which extracts of corporate information are delivered to users on a customized, real-time basis.

This evolution in information reporting is probably inevitable. But whether the large accounting firms can achieve their aspirations - either to lead the dialog or to provide whatever assurance the new world may want - is another matter that faces several hurdles.

The first is the prospect of the large firms obtaining the relief they seek from life-threatening litigation risks. That prospect was never likely under the profession's post-Enron scrutiny, and became even less so with the last U.S. elections, that delivered both houses of the legislature into the control of the plaintiff-friendly Democrats.

The large accounting firms are also floating the trial balloon of selling special "forensic audits" - investigations of an enforcement-type character, to be done at random or even on a regular schedule. The greater user cost would in theory be offset by a higher likelihood of fraud detection.

Which brings us to the second hurdle: The market's understandable skepticism. If the auditors really knew how to detect fraud more effectively, why for their own survival's sake would they not be doing that work already?

Finally, an unexplored issue in the failure of the profession to move public perception lurks in their very identity: "accountants and auditors."

No other profession needs two words to name itself. Think of about it: Doctor. Lawyer. Engineer. Priest. Soldier.
Right beneath the surface of the nomenclature lies the unreconciled duality of the competing functions. Put simply, while accountants are at least tolerated if not always welcomed in the corridors of commerce, nobody really wants an auditor around.

Accounting functions have been essential since the first trade routes opened along the Mediterranean coastline. As soon as contracts spanned time periods, transferred risk among parties, or crossed currencies, someone had to set and apply the rules and conventions for their recording and valuation. From the simplest issues of bad debt reserves to the most exotic design of complex off- balance sheet financial derivatives, the expertise of the accountants has been needed for the sake of trade.

But nobody ever welcomes the auditors - the snoopy little creeps. If the financial reporting system were put in medical or health care terms, the auditors would be the proctologists: intrusive, probing around in the dark, leaving a client feeling uncomfortable and invaded, and unable to promise that the next year's exam might not reveal a rapidly growing malignity.

As for the lack of value in the core product, the auditor's report, it has been decades since a candid banker or sophisticated investor would admit to actually reading one. If it weren't for the outmoded requirements of the securities regulators, no chief financial officer would ever pay for one.

The duality could be resolved, although compliance and regulatory regimes would be subject to fundamental change.

Here's how: The audit function could be spun off by the large firms to newly formed specialist units - perhaps linked with their global structures or freestanding - or even to the governments themselves.

With such a restructuring, the capital markets would quickly establish whether the compliance-driven output had any user value other than zero.

Freed of both the liability burden of statutory compliance and the deadening hand of out-of-date regulation, the large accounting firms would then finally have the room and freedom to invent and market new forms of both reporting and assurance, for which users would be happy to pay.

They would have to compete with the niche consultancies already working to fill the space. But they would at last be able to offer reports tailored by geography, industry, product line or materiality - all matters presently outside the limits of their liability- constrained sphere.

The prospects of change are dire, of course.

Although the large firms' recent paper is so bold, or so feckless, as actually to presume that liability reform will occur, the poor accountants are essentially friendless. Even purveyors of misery like the tobacco companies and the handgun manufacturers can buy both influence and affection in the legislative chambers. But the poverty of the accountants' message is all the more stark for their failure to attract support, much less friendship, to their cause.

For their future's sake, however, they had better improve the selling of their message. The recent report may be their last chance to make a start.