Re:Balance -- Jim Peterson

Previewing 2010 -- And a Note of Thanks

As the old year winds down to the winter solstice and all those rituals by which we mark the holiday season, a brief look ahead.

Depending on reckoning, the New Year will either end an old decade or begin the next one. Whichever, here are a few events that will feature in 2010 among the on-going challenges to the global structure of large-company assurance:

• The Supreme Court in the US may well declare the PCAOB to have been illegally constituted (here or here). If so, predictable spasms of re-enactment and ratification by the SEC cannot successfully encompass such issues as the viability of pending investigations, the legitimacy of past inspection reports, or the need to re-register all the foreign accounting firms.

In the context of those issues of contention, the legislative mischief to be wrought by a Congress offered a blank page on which to re-debate the Sarbanes/Oxley law can scarcely be imagined.

• The fits and starts of accounting standards convergence will have no more traction than a pig on roller skates. The announced retirement of Sir David Tweedie as head of the IASB (here) will take one prickly personality off-stage, but will not solve the antagonisms among competing country and industry level interests. And as the scope of complexity and judgments within both GAAP and IFRS figure to be as significant as those between reporting systems, the achievability of comparability and comprehension will remain as elusive as ever. 

• Attempts to impose liability on the large accounting firms’ international structures will continue apace. The success of BDO International in confining the Bankest verdict in Miami to the Seidman firm alone (here) means that if that $521 million exposure becomes enforceable, BDO may need to find a new US member firm – a tactic painful enough for that organization but which none of the Big Four could achieve under like conditions.

Flashpoints for structural threats will include the Madoff-related feeder funds litigations, concentrated in the US but also spread around the world, and PwC’s exposure on Satyam.  And with PwC’s Indian partners on Satyam about to observe their first full year of local imprisonment, that network's attempts to extract itself from class action exposure in the American court system (here) raise the interesting question whether submission to Indian justice is really a preferred strategy.

• Tempting as it might be to be lured into the speculation about identifying which of the Big Four firm is most likely to disintegrate under the combined pressures of litigation and government threat, in 2010 or otherwise (here), I will decline – since the determining factor is the unpredictable timing of the cases themselves. Specify the judges’ scheduled trial dates for the 25 biggest cases hanging in Damoclean fashion over the large firms – and only then would I be able to offer a view.

• More broadly, strategic decision makers in the world of financial information will continue to confront the volatility of government conduct – an under-recognized factor in their overall risk assessment methodologies.
  

The reactive nature of public officials has been marked in recent years by an ad hoc cascade of unpredictable and unintended consequences – ranging in scope and scale from the back-of-envelope bank bail-out schemes to the bonus supertax in the United Kingdom to the first-ever invention in Dubai of a default-driven debt reorganization scheme of uncertain application or reliability.

So life in the forthcoming year will not be boring. 

Meanwhile, in this space, Re:Balance observes its second birthday. Launched in January 2008, this venture was the evolution from “Balance Sheet,” the column I had the six-year privilege and good fortune to write for the International Herald Tribune.

The challenges have been fascinating, starting with the anxiety-inducing migration from old-style print. No less than the accounting firms, the IHT itself -- like the other newspapers -- pursues its fading struggle in search of a sustainable niche business model. While in the world of rapidly mutating media platforms, the near-term impact of the likes of Twitter, Facebook and Kindle will continue at a dizzying pace to re-define the information landscape.  

It has been most gratifying over these two years, both to participate in community with an expanding group of smart and incisive commentators, and to experience steady growth in readership and especially in subscribers.

For these opportunities, I thank you all for your interest, your insights and your inputs.

Merry Christmas -- best holiday wishes -- and a healthy, peaceful and prosperous New Year to all. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Survival of Seidman and BDO after Bankest

In the weeks since this column of August 18, Seidman and BDO have been keeping a brave public front on the effects of the June verdict of $521 million. But even assuming eventual success on appeal, their business challenges to maintain clients, personnel and partners through an extended process remain formidable.

For Auditors, Is This the Way the World Ends?

Originally published in the International Herald Tribune on August 18, 2007

In his 1925 poem "The Hollow Men," T.S. Eliot bleakly chants that the world ends "not with a bang but a whimper."

For large-company auditors and the fragile world of privately provided financial statement assurance, an ominous whimper was just heard in a courthouse in Miami.

In June, a jury of six citizens of Dade County, Florida, found that the Seidman accounting firm had been grossly negligent in the audit of its client E.S. Bankest, a Miami financial institution whose owners included the plaintiff, Banco Espírito Santo, which is based in Portugal.

On Monday, after one additional hour of deliberation, the jury imposed damages of $170 million on Seidman in favor of Banco Espírito Santo, adding the crowning touch of an extra $351 million in punitive damages on Tuesday.

Those are numbers well beyond the capability of the partners of Seidman, which reported total revenue of $589 million for the 2007 financial year. And Seidman won't be helped by its membership in a global network, BDO International, which - with about 30,000 employees and a combined revenue in 2006 of $3.9 billion - ranks a distant fifth behind the Big Four global accounting networks: PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, in order of size.

The Seidman firm has, perhaps quixotically, announced plans for appeal, but it faces a battle that's not so much uphill as up a cliff, and its future is, at best, mortgaged to that outcome.

Seidman could not possibly have wanted a trial over its Bankest audits. The plaintiffs claimed at trial that the audits failed to prevent or detect that Bankest, ostensibly a factoring company, was funneling funds diverted to its own principals - of whom the main players are either in or going to prison.

For Seidman, going to trial must have been an agonizing option of last resort, chosen only because it was unable to settle the case within bearable limits otherwise. Which is not surprising. Auditors have faced a formidable challenge defending themselves against claims they did not catch the bad guys, however pure their intent and skillful their efforts.

Juries have seldom been willing to look beyond the melodrama of seriously felonious executives. And in this America that increasingly elevates victim compensation to a social priority, Seidman's defense that it was competent but compromised by aggravated conditions was predictably unavailing.

Even more ominously, the Bankest verdict, which leaves Seidman and BDO teetering like a house of cards, casts doubt on the entire future of both the large global accounting networks and the one-page audit reports they deliver on consolidated corporate financial statements.

Since the disintegration of Arthur Andersen in 2002, the volume of commentary on the fragility of the audit reporting model has multiplied among the research groups and regulator-sponsored commissions.

But despite the noise levels, there have emerged neither strategies nor solutions for the threatened viability of the large firms in the face of death-threat litigation.

Topics in this dialog include the desirability of expanded competition for the Big Four, and increased auditor choice at the global company level. But the Seidman experience, which shows the smaller networks to be even more vulnerable than their larger counterparts, ends all expectation that a Big Fifth firm might emerge.

Never a realistic possibility in light of limits on the geographic and technical depth of the smaller networks, the idea is now as dead as Seidman's hopes for the trial.

Meanwhile, based on economic modeling done last autumn for the European Commission (here) ,  there is an estimated upper limit of $1.8 billion, or some €1.4 billion, that the partners' capital accounts of even the strongest of the Big Four firms might absorb without collapse. And the real survival risk threshold could be far lower, down in the range of $400 million.

But the impact can take the form of either judgments or settlements. While the Big Four firms have repeatedly shown that they could not or would not go to trial in cases at the level faced by Seidman, their payouts continue: Deloitte settled part of its Parmalat exposure this spring by agreeing with an administrator to pay $149 million, and in July, PricewaterhouseCoopers settled for $225 million with the shareholders of Tyco.

Yet nothing in the politicized debate on limiting auditor liability - whether in Brussels, London or Washington - suggests that lawmakers have any intention of providing the accountants with protection from litigation exposure at thresholds low enough to allow survival.

The Bankest verdict against Seidman was not the first shot across the bow of auditor survivability. That warning goes back to the disintegration of Laventhol & Horwath, a respected second-tier firm, under an adverse jury verdict in Texas in 1989. Ever since, the creaky vehicle of private audit assurance has been lurching along, always hostage to the next, and potentially fatal, blow.

As the number of firms still standing continues to shrink, the prospects for the survivors look increasingly grim.