Re:Balance -- Jim Peterson

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

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

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

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

•    That the traditional form of auditor’s report is obsolete and provides no investor value, especially compared to the possible forms of assurance that are impossible under the current model -- here;

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

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

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

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

Setting Free the Auditors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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