Re:Balance -- Jim Peterson

The Big Four Accounting Firms' Financial Tipping Point -- Time for a Fresh Look

How quickly time does fly. It’s been three long years since my last review of the litigation “tipping point” that would disintegrate the fragile business models of the Big Four accounting networks. 

It’s time again. And not just because of the regulators’ threatened imposition of mandatory auditor rotation and other limitations sure to impair the quality of audits -- both PCAOB Chairman James Doty and EU markets commissioner Michel Barnier (see his November 30 press release, FAQ’s and provisional directive).

Those worrying about the incomprehensibility of Barnier’s financial and market thresholds for splitting off the non-audit practices of the European networks or injecting second-firm auditors (here) are looking in the wrong place.

That’s because the inventory of multi-billion dollar financial scandals in the firms’ client lists is constantly refreshed: revelations this fall alone include Kweku Adoboli’s roguish trading at UBS, the $1.2 billion shortfall in customer accounts at MF Global, and the decades of under-performance at Olympus concealed by dubious advisors’ fees.

Back in September 2006 – to re-set, and for new readers -- a report by the consulting firm London Economics to then-EU markets commissioner Charlie McCreevy (here) modeled the threshold limits of financial pain that would be tolerable to a Big Four UK partnership, before its owners would withdraw their loyalty and their capital and vote with their feet[1] – a process that would, unfortunately, lead to the rapid disintegration of the entire franchise of privately-provided assurance to the world’s large public companies.

I applied the London methodology to the global financial results published by the Big Four, in December 2006 and again in October 2008 – yielding calculations that, however ominous, were never disputed, nor have they been displaced by alternate models or methods.

It is poorly appreciated, if at all, that the private partnerships comprising the large international accounting networks operate with razor-thin levels of capital, for three reasons:

• Their major working capital needs – employee salaries, space costs and technology and methodology investments – are financed out of the fire-hose cash stream of client-derived revenues.

• The tax codes of the largest economies are cash-based for partnerships, creating a powerful incentive for the firms to distribute current income out to the partners to match with their tax liabilities.

• And, there being no alternatively valuable need or opportunity for the deployment of excess capital under the firms’ current business models, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding pens.

Latest available figures for the Big Four indicate total annual global revenues of some $ 102 billion.[2]

Applied to those figures, the model indicates that the break-up threshold for any one of the Big Four firm’s litigation “worst-cases” would be in the range from a maximum of $ 6 billion down to $ 2.2 billion, if viewed at the global level.

That is a considerable increase from the earlier numbers, owing to the great leap in total big-firm revenues in the intervening years.

But cautions remain. Most importantly, cohesion of the international networks under the strain of death-threat litigation, or the extended availability of collegial cross-border financial support, cannot be assumed. Arthur Andersen’s rapid disintegration in 2002 with the flight of its non-US member firms is illustrative.

So it is necessary to look at the bust-up range based on figures alone from the Americas, the most hazardous region. If left to their local resources, as was Andersen’s US firm, the disintegration range shrinks, from a maximum of less than $ 3 billion down to a truly frightening $ 675 million.

Amounts at that level compare ominously with the litigation settlements recently extracted from the larger debacles of the last decade – examples led by Bank of America’s post-Countrywide mortgage-securities settlement of $8.5 billion (here) and including such investor settlements as Enron ($7.2 billion), WorldCom ($6.2 billion) and Tyco ($3.2 billion) (here).

But those amounts were only available because inflicted on the investor-funded balance sheets of the corporations contributing to the settlements – resources not available to the private accounting partnerships. And they are even more darkly comparable with the exposures looming in the pending claims inventory.

True, in recent months the large accounting firms have enjoyed remarkable success in disposing of large litigations for modest sums – examples include KPMG resolving Countrywide for $ 24 million (here) and New Century for $ 45 million (here), and Deloitte settling Washington Mutual for $ 18.5 million (here).

However, hope for the indefinite continuation of such forbearance on the part of the plaintiffs is not a strategy, but only a wish.

As the catastrophic impact of “black swan” events makes clear, it only takes one. And at that tipping point, all the marginal fiddling by Barnier, Doty and their ilk becomes academic.

 

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[1] To summarize the model, as I wrote previously, “The original London study assumed that, in a highly-charged crisis environment dominated by the pressure and publicity of a massive adverse litigation result, critical numbers of partners would defect, so as to put a firm into a death spiral, if faced with a profit reduction of from 15 to 20 percent and extending over three or four years.”

[2] Deloitte, as of May 31, 2011: Global revenue $ 28.8, Americas $ 14.3 (here).

   Ernst & Young, as of June 30, 2011: Global revenue $ 22.9, Americas $ 8.9 (here).

   KPMG, as of September 30, 2010: Global revenue $ 20.6, Americas $ 6.4 (here).

   PwC, as of June 30, 2011: Global revenue $ 29.2, Americas $14.1 (here).           

 

 

 

A Lesson from the PCAOB's Inspection Reports -- Never Wrestle with a Pig

The October 17 release by the Public Company Accounting Oversight Board of previously-undisclosed portions of its 2008 inspection report on the Deloitte firm generated predictable bursts of umbrage from the usual suspects --  e.g.,  here, here and here.

The cottage industry of the professions’ critics may be satisfied with nothing less than the collapse of the large accounting firms’ business model and the entire franchise of privately-provided assurance. But because self-interest requires a steady supply of stones on which to grind their axes, the sniff of sanctimony resembles Captain Renault’s “shock” at the discovery of gambling at Rick’s Casablanca nightclub.

From its press release, the Board:

“takes very seriously the importance of firms making sufficient progress on quality control issues identified in an inspection report in the 12 months following the report. …The Board can and does make the relevant criticisms public when a firm has failed to do so." 

Flawed, opaque and ineffectual the PCAOB’s inspection and reporting process surely is – measured by its failure to achieve public credibility as a constructive force for improved financial reporting quality, even as it adds to the lives of auditors only added stress and box-ticking.  

That said, here is a message for the large firms: there are at least two grounds on which to question the reflexive approach taken by Deloitte, to fight off the inspection process by repeating the theme that:

“Professional judgments of reasonable and highly competent people may differ as to the nature and extent of necessary auditing procedures, conclusions reached and required documentation. We believe that reasonable judgments should not be second guessed and, therefore, disagree with a number of comments as indicated below."

The first is simply that it is bad form to convey to a regulator a tone of unvaryingly stubborn antagonism – a lesson that Arthur Andersen’s death spiral should have etched in memory. Having neither competence nor authority to act on a preventive basis, the PCAOB’s only tool is deployment of its functionaries to use their hindsight after the fact. So its minions must feel the hostility of disrespect, when challenged in their very raison d’être. 

Or as my grandfather would say, back on the farm, “Don’t wrestle with a pig. You get covered with pig-sh*t, and the pig actually likes it.”

Second and more nuanced – the accounting profession’s on-going and unsuccessful struggle with the public expectation of “zero defects” performance is not aided by the futile repetition of arguments that all judgment calls should go its way.

Instead, successful improvement strategies involve the candid recognition that performance shortcomings present learning opportunities, however unpleasant. The fields of engineering, air traffic safety and hospital ER techniques are exemplary – whereas the auditing profession has never acknowledged or embraced the utility of an effective forum for “failure study.”

“Close calls,” when rationalized away, are not problems fully diagnosed or properly solved, but rather are only buried hostages to fortune, lurking and growing and waiting to erupt.

So a mindset at senior levels, that outsiders’ criticism is to be deflected as nuisance and distraction, is at least an impediment to improvement, and perhaps an invitation to disaster. Examples range from the NASA management’s over-ride and launch of the doomed shuttle Challenger in 1986, to the chain of multi-level risk assessment faults leading to the BP oil well blow-out, to the SEC’s blinkered refusal to credit the warnings around Bernie Madoff.

None of this is to single out Deloittes – not least because, frisky as he is acting these days, it’s a sure bet that PCAOB chairman Doty has a stack of other Big Four reports ready for near-term release on a slow news day, when the others will suffer in their turn.[1]   

It is rather to suggest – in terms my Risk Management classes address every week – that it is impossible to achieve improvement if you can’t really measure how good you are. 

That realization comes hard – especially when served up by a crude and intrusive regulator – but it still offers a pathway to wisdom.     

 

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[1] And worth noting -- my own dedication to the importance of professionally-provided accounting and assurance – services as old as human commerce – extends back to my first two experiences, decades ago – involving massive problems for Deloitte’s US firm, Haskins & Sells as it then was, each of which led to changes in accepted auditing standards. And sharp-eyed readers have observed the homage on this blog’s banner -- the report issued by Mr. Deloitte himself in 1850 – the first, by my research, and unarguably truly significant, by an independent auditor on a large public company.  

A Prescription for What Ails Large-Company Audit: Real Medicine, for a Change

“Reality must take precedence over public relations, for nature cannot be fooled.”

            -- Physicist Richard Feynman's appendix to the Rogers Commission Report on the space shuttle Challenger disaster, January 28, 1986   

 A reader of my July 17 post acknowledged the continuing sterility of the dialog among the community of financial statement users, about the degraded status of the standard auditors’ report and the deep illness threatening the survival of the large accounting firms. But he chided me for offering only “bromides” rather than my own substantive prescription.

I felt the point of that needle – even though potential solutions have figured for the nearly ten years since this blog’s predecessor, my column "Balance Sheet," launched in the International Herald Tribune.

After the Enron debacle, the politicians’ infliction of Sarbanes/Oxley, and the many-faceted and still-unfolding events of the financial crisis, book-length treatment is surely called for -- despite the discouraging message from authors’ agents and publishers, that while the topic is worthy, the size of the interested audience would not support their investment.

Faute de mieux, I have stayed this course, appreciating the interest and support of a readership well prepared to share suggestions and criticisms.

It is a challenge to address the complex issues, within both column-length constraints and a comprehensive “holistic approach,” such as called for in June by PCAOB chairman James Doty (here), who himself lacks the vision, authority or resources to achieve it.

But by way of synthesis, a snapshot is possible of a sustainable future, using links back to the archives for detail.

First, a few background assumptions:

• A forthright reading of the projects to re-consider the scope and language of the standard auditors’ report, by the PCAOB and the IAASB among others, confirms an emerging consensus that the current “pass/fail” report is obsolete, serves no purpose other than securities laws compliance, and should be supplanted by assurance of real value.

• The existential threat hanging over the Big Four firms’ complete dominance of the large-company audit market -- the “supply side” – is simply not addressed by any of the so-called “solutions” addressed to market concentration – whether mandatory rotation, break-up or new entries, liability reforms, audit catastrophe insurance or bonds, living wills, leadership replacement, etc., etc., blah, blah, blah. As the first head of the PCAOB confirmed, regulators “don’t have a clue” – a widely shared and unchanged attitude of denial.

• There is no credible case for government-controlled delivery of audits worth the effort and expense – whether by direct execution, engagement assignments or otherwise. The output of the artificial and pathetic “profession” that would exist under such regimes would be inferior even to today’s devalued state, much less to the evolved conditions now called for.  

• And, it is time to acknowledge, the entire intellectually fragile structure of auditor independence is anachronistic, ill-suited to today’s conditions, and deleterious to both performance quality and the potential for useful change – a sacred cow that should be taken out and put to a quick and humane end (here and here).

So, now what? 

A framework does exist for regulators to license or charter sustainable audit-only firms (here). But – if and only if – a reconfigured legal and regulatory environment both permits, invites and encourages: 

• Full-service relationships between auditors and providers of other services.
• The attraction and deployment of outside capital, as would be required to support such new multi-service providers, with corresponding changes in permissible ownership structures.
• The appropriate involvement of meaningful regulatory oversight, quality enforcement and investor rights recognition.
• The emergence of geographic and industry-based new competitors.
• And, perhaps, even the return of today’s understandably reluctant insurance industry. 

Under such a fundamentally re-engineered regime, truly new and valuable forms of reporting could be designed and delivered (here and here).

These could be responsive to the needs of financial management and audit committees, welcomed by both executive teams and directors alike, and subscribed to by users under sustainable liability terms). They could be, at the same time, respectful of the value perceived by shareholders and others of the influential presence of “outside experts.” 

Simultaneous attention to all aspects of this framework is essential, however, because until then – as today’s impasse shows -- neither issuers nor auditors have any incentive to take on the increases in both cost and liability imposed under today’s exposed conditions.

I have been calling for years for an adult dialog among the inter-locking and antagonistic interests, who today are only wasting their energy in paralysis and finger-pointing. Without seeking endorsement or even agreement, I suggest that there is much more available here than “bromides.” 

Be the judges – and please let me know.   

 

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The "Independent" Auditor's Real Client? Time to Re-Assess, I Kid You Not

 "Ahh, but the strawberries -- that's where I had them. They laughed at me and made jokes, but I proved beyond the shadow of a doubt and with geometric logic that a duplicate key to the wardroom icebox did exist, and I'd have produced that key if they hadn't pulled the Caine out of action"

    --Capt. Philip Francis Queeg, 1954

Comprehensive review of the scope and language of the standard auditors’ report has been long overdue. So with measured enthusiasm (here and here), the initiatives of both the Public Company Accounting Oversight Board and the International Auditing and Assurance Standards Board are welcome.

High on the list of barriers to clear thinking and potentially constructive evolution, however, is the persistent canard, renewed by PCAOB member Steven Harris at its June 21 public meeting (here), that auditors “must fully embrace the concept that the company paying their fee is not their client.”

This proposition is confusing in logic, wrong in history, and malign in its influence. Until snuffed out once for all, it will continue to deflect and distract from the achievable task of re-engineering a role for outside auditors that brings real value to the community of financial statement users.

Since the middle of the 19^th century, when Mr. Deloitte and his pioneering colleagues were first engaged to assist the “auditors” of Victorian-era public companies – themselves selected from among the body of corporate shareholders, to advise their fellows in their shared financial interests – the auditor/client relationship has been contractual, consensual and private.

The appliqué of “public interest” has been allowed not only to stick, but to become an incrustation on the auditors’ appropriate functions. Fostered since its infancy by the newly-invented profession itself, to its discredit and lately to its mortal threat, the label did fend off – if only temporarily – the prospect of government-provided assurance – but at high cost and under the now-realized hazard of exaggeration and misapprehension of its capacities.

The shaky structure on which Harris bases his claim, that “the ultimate client of an auditor of any publicly traded company must be investors” is the 1984 case of United States v. Arthur Young. There, perpetuating the unfortunately long tradition of judicial malappreciation of the auditors’ role, Chief Justice Burger invoked the inapposite image of the “public watchdog” -- that “the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

As a matter of jurisprudence, Burger’s gratuitous dictum was unnecessary to the Court’s holding that tax accrual working papers could be reached by IRS subpoena.

And as a matter of unexamined rhetoric, Burger defied the logic of canine behavior, by expecting even the most vigilant watchdog to bite the very hand that feeds it.  

Events have now shown that on such a tenuous rationale, the bulky but fragile edifice of constrained client service and “appearance of independence” cannot stand. 

Critics such as Harris of the “pass/fail” audit report model have much to complain of – but there will be no solutions in shooting at the messengers, for continuing to deliver this outdated and devalued commodity product. 

Instead, history provides many examples of the dangers that lurk in broadening the distance that separates the payor of fees or benefits from the subsidized interests ostensibly served:

• Raising the limits on depositors’ insurance incentivized the reckless behavior of the American savings and loan institutions in the 1980’s, underlying their ruinous boom-and-bust.

• Lodging the management of health care cost reimbursement decisions with self-interested insurers has opened the doors to the waste, abuse and mis-allocations in the pricing and delivery of medical services.

• And most recently, requiring an issuer-paid rating agency’s report as a “green light” to sell complex derivatives was a central element in the inflation of the subprime-mortgage driven crisis that has plagued the financial markets for four years and counting.

None of which is to say that the “agency problem” of close auditor relationships with corporate boards and managements can be addressed successfully by the further intrusion of government. The prospect that an audit regulator could take on and satisfy the task of providing even today’s out-dated “pass/fail” assurance is beyond Panglossian fantasy or imagination. 

Rather, hope for progress lies in a realistic re-framing of the results that can reasonably be expected from the auditors, in an environment where legitimate and valuable new forms of assurance can be designed and delivered.

Which requires putting aside inflated language, moderating unrealistic expectations, and nurturing the profession’s acknowledged and considerable expertise.

 

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The Role and Relevance of Audits: PCAOB Chairman Doty Creates His Own Expectations Gap

 There are at least two positive reasons for attention to the New York speech delivered on May 5 by the PCAOB’s newbie chairman James Doty – here.

Although no rhetorical threat to the real wordsmiths of the Beltway, Doty has the ability to turn an adult phrase -- finally re-writing the agency’s longstanding pattern of turgid language and opaque vision.

As can be seen, first, in his readiness to reject the “structural alternatives such as a third-party payor or insurance-based system,” or to see the trial balloons floated in the UK or in Brussels to break up the Big Four – properly “the bailiwick of competition authorities” – as having a “negative effect on audit quality.”

Modest applause – these diversionary detours being long since exposed as dead ends (see here and here). 

Second, Doty offers relief at last – although perhaps inadvertently -- from the otherwise reluctant but compelling conclusion that since passage of the Sarbanes-Oxley law in 2002, the PCAOB has managed to pass from immature ineffectiveness directly to self-perpetuating inertia without ever achieving a record of real accomplishment.

Namely, a healthy admission of the agency's inward focus is at least implicit in Doty’s acknowledgement that auditor oversight and quality enforcement are shrouded in PCAOB confidentiality and concealed from public transparency and deterrent impact. The same inference is recognizable in Doty’s reference to recently commenced “joint inspections with U.K. and Swiss authorities” – surely two of the lowest-hanging fruits dangling from the limbs of cross-border enforcement – only showing the glacial pace of progress over nine years.

Meanwhile for candor and completeness, his concession of an inability “to inspect a registered firm’s work” in context of the “growth in the number and size of Chinese companies seeking access to capital in U.S. securities markets” requires acknowledgement of this year’s outbreak of litigation claims against Chinese issuers – catalogued by the ever-informative Kevin LaCroix’s D&O Diary, and the risk-based subtext of the PCAOB’s own March-dated research note.  

Credit as due for these positions, but the Chairman ventures onto even riskier ground.

To start, his cheerleading that the auditors’ “lofty status” as “guardian of a cultural value” is akin in importance to electricity or water, presumes to invoke the name and record of the late chief accountant of the SEC. But the legacy of Sandy Burton’s 1980’s advocacy for greater auditor responsibility only highlights the absence of substantive change over the span of an entire generation. 

Likewise, Doty’s critique of the payment model by which “the auditor is hired and paid by the company itself” is devoid of vision for change in a structure embraced since the emergence of independent assurance to assist shareholders in the Victorian era of the 1850’s.

The market's vote for persistence of “client pays” does not fault the limited influence of audit committees on economic relationships having 150 years of history, pace Doty’s slap at their lack of impact. The durability of that model and the absence of viable alternatives only expose, instead, the intellectual fragility of the entire cosmetic attempt to regulate “appearances of independence” and the richly-deserving consignment of that sacred cow to a decent burial (as I have written for years – see here and here). 

Rather, it is the narrow and anachronistic language of the current compliance-oriented audit report itself – a document having value in today’s environment not by the free choice of issuers or users but only because required by the fraternity of regulators to which Doty himself belongs – that operates as a shackle on innovation.

Here Doty stands exposed. Correctly recognizing that “auditors don’t have a natural incentive to evolve their reports to what investors want” – a position long argued (e.g., here, here and here) – Doty has put down a major marker: He promises a “concept release” for early summer, to consider “how the auditor’s report can be changed to provide more useful, relevant and timely information.”

Can the Chairman really mean it? And how, without conceding that his own agency (along with the SEC) holds the keys to the lock?

He avows that “there is no silver bullet to address these challenges.”

But in this he is wrong. That bullet today is loaded in the deadly weapon of litigation roulette, which aims existential exposure at the large firms for their issuance of the very reports Doty purports to recognize as failing to deliver value to users.

To disarm that weapon – to create and nourish an environment in which real innovation in assurance and investor value can be brought forth – will require a leader's brave step, up to now unimaginable: scrap as worn-out and useless the obsolete one-page compliance report, along with the devastating machinery of liability that has grown to encage it, and start with fresh and creative authorship, written on an entirely blank page.

The first PCAOB chairman left office with the admission that regulators “don’t have a clue”(here). Today's occupant not only has the opportunity to show otherwise. Doty's speech makes hostage to fortune and accountability in office his own readiness to act.

 

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The PCAOB Settlement in Satyam: PwC Agrees to Fall on its Pen-Knife

“Two aristocrats challenge each other to see which can come up with the larger number. The second agrees to the contest, concentrates for a few minutes, and proudly announces, “Three.” The proposer of the game is quiet for half an hour, then finally shrugs and concedes defeat.”

-- John Allen Paulos, “Innumeracy,” 1988

 

 The PCAOB’s April 5 settlement with the Indian firms of the PwC network, over the billion-dollar fraud at Satyam Computer Services Limited, adds a $1.5 million fine to the six million dollars the auditors also agreed to cough up to the SEC.

(Statements from the agencies are here and here; see Going Concern for the orders; and the NYT for statements from PwC.)

The amount compares to the aggregate salary of the five PCAOB members of $2,366,000. It would be a small fraction of either the annual compensation of PwC’s global chief Dennis Nally, or the firm’s legal fees on Satyam to date. And even measured by the $ 550 million ponied up by Goldman Sachs under its August 2010 SEC settlement of its one-issue dispute over the “Abacus” derivative peddled by its fabulous Fabrice Tourre (here), the amount is derisory. 

The Big Four giant is still facing on-going investor claims, to be sure. But the exposure is well-fenced; the Supreme Court’s June 2010 decision in Morrison closed the doors of the American courts to foreign securities claimants who bought their shares abroad, and the inexperienced Indian judicial system lacks the competence to be an attractive plaintiffs’ venue.

Consider the motives from the regulatory perspective. The settlement timing ahead of the April 6 hearing of the Senate Finance Committee on the role of the accounting profession in the financial crisis (here) gave senior officials a public forum. And the media coverage allowed the SEC’s enforcement head Bob Khuzami and FCPA unit chief Cheryl Scarboro, and the PCAOB’s chairman Jim Doty and his enforcement head Claudius Modesti, all to strut their achievement against foreign auditors – even while avoiding the obligation actually to try their case across international borders.

From the PwC perspective, meanwhile, the chance for a cheap exit from a major problem would have been a no-brainer. Consider:

First, an enforcement ding on the Satyam engagements had to be coming, sooner or later. From the PCAOB’s order – which PwC agreed not to contest – the Indian engagement teams on the audits from 2005 through 2008 basically did not:

• Adequately audit the company’s cash positions
• Control the confirmation process on bank balances or accounts receivable
• Pursue indications of inconsistent information or control weaknesses
• Follow PwC global directives on audit execution
• Inform or advise higher-level quality oversight personnel
• Document the work actually done (or not) in the work-papers, until subsequent back-dating while already under regulatory scrutiny

So a strategic decision not to defend the indefensible indicates early recognition of a step toward sustainable credibility. 

As for the sanctions – PwC’s undertakings on future practice quality, staffing, training and internal oversight are no more than necessary for an enterprise with aspirations to professionalism; the two-year presence of an outside monitor only adds one more stranger to the list of foreign intruders imposed on its Indian practice; and the six-month restraint on new SEC clients runs only to the settling Indian firms, so does not inhibit either the global network or its other Indian affiliates.

And, lastly, the financial impact of the fines on the massive PwC network is no more than a dime added to a roll of nickels.

For good measure, with the week’s news cycle dominated by military activities in Libya and a threatened government shut-down in Washington, and subsidiary attention to post-earthquake Japan’s nuclear hazards and Silvio Berlusconi’s “bunga bunga” trial, the entire story will drop off the media screen in less than no time.

Predictably, critics of the accounting profession who are unwilling to settle for less than the scalps of the Big Four leaders nailed to an enforcer’s door will make their outrage known.

But they will fail to acknowledge that both the regulators and PwC itself are only acting in full accordance with their respective DNA.

So once again, this settlement points up the challenge to the long-term achievability of a valuable, sustainable assurance function, to serve the issuers and users of the financial information of global-scale companies: the terms of the discourse are revealed as hopelessly inadequate.

 

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The House of Lords -- Experienced with "Disconcerting Complacency" -- Looks at the Market Concentration and Role of the Auditors

Adulatory commentators are treating the March 30 report of the House of Lords Economic Affairs Committee on the market concentration of the Big Four audit firms and their role in the financial crisis (here) as a call to arms not heard since King Henry’s exhortation to his troops on St. Crispian’s Eve.

While the print media played it pretty much with a straight bat (here the Financial Times, the Guardian, the WSJ and the NYT), the blogging community went into adjectives-on-steroids: “hard-hitting” (both Ian Fraser and AccountingWeb), a “watershed” (Accountancy Age), “tough, no-nonsense” (BigFourBlog) and “skewers the auditors” (Francine McKenna).  

Yet soft a while. This on-high manifestation of the Lords’ work is hardly “band of brothers” material.

Truth told, other than its sound-bite charge that the auditors of the UK banks were “disconcertingly complacent” in carrying out their mission, the report is pitiably thin in substance:

Its most solid recommendation, first, is for mandatory five-year auditor rotation – an approach backed by nothing but hope for beneficial effects, and conspicuous by its adverse unintended consequences in Italy, the only major country with experience.

Second, the suggestion of “living wills,” for the relief of an audit firm in crisis, would follow the distinctly inappropriate model for rehabilitating a failing bank – which is an entirely different proposition. Bank separation of the good from the toxic involves a balance sheet of identifiable if hard-to-value assets and liabilities, to be worked through by a fungible and entirely replaceable leadership team – whereas the only value in a service-based accountancy partnership resides in its reputation and the highly-mobile skills of its people – both of which (as was shown in the Andersen disintegration) can dissipate faster than any putative rescuer can possibly control.

Third, the extent of Big Four concentration at the upper end of the audit market long pre-dates Andersen’s collapse in 2002. So the Lords’ buck-passing to the Office of Fair Trade, to re-visit yet again the age-old and insoluble matter of large-firm concentration, is hardly inspired or inspirational – especially in the complete absence of any indication of authority or vision as to how a split of resources and expertise could increase auditor choice or quality of performance.

Specifically: to split the large firms along industry lines would not increase choice. A Big Four firm depleted of its global-scale expertise in a complex sector – say, insurance or communications or defense contracting -- would have no more motivation or access to resources for a re-start than the current mid-sized firms – whose lack of appetite for the risks and challenges is already manifest.

Yet the alternative -- surgical bifurcation of existing teams of talent -- would devolve onto new firms, now smaller and weaker, all the existential challenges looming today over the Big Four themselves, along with the added burden of cost and management diversion to build duplicate centers of technical, industry, quality and risk management competence.

So on the actual content of the Lords report, it is either laughable or pathetic to invoke the image of Hercules confronting the stables of King Augeas. Instead of donning its boots and seizing a pitchfork, the Lords report holds a hanky to its delicate nose as it minces past the shit-pile, all the while whining that someone else, evidently the OFT, ought to get on with the stable boy’s dirty work.

Shame on the House of Lords committee, for a lazy approach to important issues of real substance. More shame on the observers failing to hold them to account.  


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Replace the Big Four with Audits by Government? More Heat in the Kitchen -- and Less Light

What will it take, once for all, to lay forever the ghastly fantasy that audits done by government employees could provide any value to the world’s capital markets?

Like Banquo’s ghost, the gruesome spectre keeps stalking the discourse on the troubled state of privately-provided assurance – for now, dominated for global-scale companies by the fragile and threatened Big Four.

In search for a metaphor with an edge sharp enough to the task, consider:

Does anyone choosing a restaurant ever give one second’s thought to the local health inspector’s report on the state of the kitchen?

I thought not.

Never did a restaurant owner welcome diners or execute a menu with the least consideration of the requirement to pay a nuisance fee, just in order to post on his back wall the same ticket of compliance issued to everyone else – whether the tea shop or the burger joint or the elite purveyor of haute cuisine. 

Nor does that annual documentation provide any significant comfort.

On one hand, whatever that irrelevant certificate may say, competition applies relentless quality pressure in the narrow-margin food service business. A chef has ample incentive for the sake of survival to conform to the standards generally accepted among his peer group – whether running a gyros wagon or a three-starred temple of gastronomy. With ready access to reviewers’ critiques and customers’ word-of-mouth, a clientele will quickly vote the extent of its satisfaction and loyalty with its feet.

So irrespective of the commodity language of the inspector’s report, quality and value will quickly reach equilibrium.

On the other hand, the narrow limits of an inspector’s box-tick are illuminated by the commentators with inside knowledge. The celebrity ex-chef and international foodie, Anthony Bourdain, exposes to the point of hilarity the dirty little secrets of fully-compliant professional kitchens: never order fish on Monday that was carried over the weekend – the best chance for freshness is the chef’s daily special, because of the high volume and extra attention – and for salmonella’s sake, keep distance from the salad bar, never knowing who or what has rooted around there.

Bourdain makes it clear that a restaurant inspector’s annual pass-through leaves customers un-informed about what lurks beneath the grease trap or inside the meat cooler – consigning their reliance instead to the combination of peer influence and managerial attention to reputation and survival.

Which should validate the efficacy of market dynamics over further regulatory intrusion over the audit sector: restaurants, like corporate issuers, fail for multiple reasons, but above a minimal level of legitimacy, not for lack of code compliance.

Just as a health inspector is in no position to assure the quality of a dining experience, audit by government agencies would be helpless in the search for financial statement assurance of any real value -- too little, too slow, and far too late behind the speed of creative private enterprise.

Government audits could be imposed, of course – especially in the event of Big Four disintegration. But the impulse would be expedient and superficial – primarily under politicized motivations as cover for legislators and secondarily to serve the self-interested bureaucracy that would quickly become entrenched.

And the results would be much like the other models for agency-enforced compliance. Effectiveness would be measured by easily–measured inputs rather than defects exposed – think of the numbers of grandmother pat-downs reported by airport security, or inspections conducted by the PCAOB – neither of which has a record of detection or deterrence for all the wasted effort, disruption and expense.

Other examples abound. Consider drivers’ licenses. Above a minimal threshold level, anyone can get one – only to support a large and costly administrative structure interested primarily in its own perpetual existence – while delivering a compliance certificate offering no assurance on the quality of the holder’s ability behind the wheel. 

The entirely justifiable public dissatisfaction with the institutions at the heart of the financial crisis of the last four years, reflected in the legal claims working through the court systems – Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, New Century, Countrywide, Washington Mutual, as the start of the US list; plus endless examples elsewhere that would include banks in the UK and across Europe from Germany through Ireland to Iceland – rightly challenges the utility of the current financial reporting model and the performance value of privately-delivered assurance.

But great care and caution is required before speculating that the manifest deficiency of an existing model would be relieved by trashing it for another of uncertain and highly doubtful capabilities.

Or as a percipient restaurant critic might suggest – the leap from a well-seasoned but encrusted frying pan may be into an unknown and far more dangerous fire.

 

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Evolution of the Accounting Model: What Would Darwin Say?

So where will the initiative for innovation really come from, in the inevitable but elusive evolution of financial reporting and assurance?

 Not from what passes for leadership, where the paralysis is complete:

• Not in the United Kingdom, where the House of Lords inquiry is wagging fingers at the politicized nature of the banks’ accounting (as Ian Fraser writes from London) and the cozy discussions on “going concern” between the Bank of England and the large accounting firms (see Francine McKenna). 

• Not in Brussels, where the EC green paper was an embarrassment (here) and the Big Four are winkling out crisis-survival plans (summarized here and detailed on their websites) -- unfortunately no more achievable to preserve a disintegrating network of private partnerships than the ill-fated attempt to foist outside management upon the partners of Arthur Andersen (here).

• Not in the US Congress, which flailed away at the financial crisis without a nanosecond’s attention or a single word in the Dodd-Frank legislation on the fragile state of the large-company audit market.

• And not even among the authorized critics – the squabbling parties comprising the Financial Crisis Inquiry Commission having issued their variously antagonistic reports without even glancing at the role of the auditors (nowhere better summarized than by Tom Selling).

Evolutionary biology teaches that successful adaptations do not occur at the crowded center of a population, where conformity pressures suppress deviance and outliers. Instead, successful mutations emerge under stress at the margins.

Recall -- the dinosaurs thrived unchallenged for millennia, until sudden climate change exposed the vulnerability of their inflexible lack of ability to adjust.

It’s the same with industrial development -- mainstream complacency under the illusion of stability puts a damper on innovation. Consider the lag in cell-phone technology and acceptance in the large English-speaking countries, under the inertia of their large fixed-line capacity, subject to leadership take-over and exploitation by the Finns and the Japanese.

For decades the Big Three automakers in the US – the dinosaurs’ counterparts – delivered dull commodity products and burdened themselves with unbearable costs, ignoring the Japanese whose under-the-radar combination of small-engine expertise and meticulous quality processes evolved world-class cars.

The unrecognized fragility of a seemingly stable structure is exposed by surprise disruptions at its outer edges. An assassination in far-off Sarajevo lit the fuse on pre-war Europe’s vulnerability to collapse in 1914. Last month in Tunisia, the self-sacrifice of a fruit vendor in an obscure market street triggered demonstrations fatal to a despotic regime -- today spreading to engulf Egypt’s government and reverberating in every corner of the Arab world.

Large-country regulators and law enforcement agencies in the post-Andersen world have shown their disinclination either to evolve the financial reporting model or to force the re-engineering of the Big Four dominance of global audit – the only significant claim being the state-level action in New York against Ernst & Young over the repo accounting at Lehman Brothers.

Instead, evolution could well occur out at the fringe. A country or an industry sector may be so small as to be immature, unpredictable and ignored, but large enough to disrupt the global regimes for reporting and assurance. Under conflagration conditions, the fatal match could touch anywhere in the fuel pile.

That is, many economies are too small for significant global effect. The challenges of Satyam in India could ultimately cost PwC its practice organization there, but without a hiccup at the global scale; likewise the problems of the banks in Iceland are too localized to metastasize.   

But no large accounting network could survive the loss of practice in a country of G8 scale – say France, Germany, Spain or Italy in Europe, or Japan or Korea in Asia – because of the number of large companies relying on Big Four services there.

Just as most of the once-great sauri ended up sunk in the tar pits, to have their fossils excavated by the descendants of the tiny fury creatures once disregarded at their feet – so too the future of financial statement assurance will involve competition from new firms grown from small size and great agility.

Once the clean-slate opportunity is provided by the eventual recognition that the traditional one-page audit report is obsolete (and here is welcome the voice of Professor David Albrecht’s commentary and advocacy), the scale and structure of the Big Four will be otiose and unnecessary.

Some fragments might evolve to survive. A few dinosaurs did pass on their genetic code to become the modern world’s birds, whose rainbow varieties have thrived in successful competition with each other and with predators up and down the food chain.

Evolution can be stalled, but it will not be stopped. The successor to the auditors’ report, stuck in its tracks since the 1930’s, may break out in some obscure and unexpected mutation. When it does, the landscape of assurance will be populated by a different menagerie of creatures. 

 

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The Audit Model Is Broken -- "Re:Balance" Has Its Third Birthday -- And The Message Hasn't Changed

And lo, it came to pass in the dark time of winter, that there was a grand convergence. All the scribes did their scribbling, and the soothsayers said their sooths, and the stars came into alignment. There was loud wailing, and an anguished chorus sang in unison, and a great outcry was heard in the land:

“The model is broken.”

All the major voices of concern over the unsustainable state of the financial reporting and audit model sang the same year-end theme.

For the academics, Dave Albrecht was most terse (December 15):

“The audit model is broken.  Everybody knows it. … Therefore, financial reporting is broken.”

The best critic of the dysfunction in reporting standards, Tom Selling, said (November 9):

“none of the (proffered) solutions fix the root causes of the problems with the auditing profession…. the sad irony is that nobody is as happy as they could be with the current state of affairs.”

Expect to hear from a plaintiffs’ lawyer? Jake Zamansky obliged (January 5) with a shout-out for Andrew Cuomo’s suit against Ernst & Young over the repo accounting at Lehman Brothers:

“Lehman Bros’ actions, and Ernst & Young turning a blind eye to them, stink to high heaven. … As the financial and subprime crisis unfolded, where were the auditors who were the “gatekeepers” charged with protecting shareholders?”

Francine McKenna could be counted on – re-cycling a prior piece (also January 5):

“I’ve said throughout the subprime crisis that morphed into the financial crisis that fraud played a role and the auditors were, at least, negligent and potentially complicit in that fraud."

On the UK side of the Atlantic, both Ian Fraser (December 21) and Richard Murphy the next day resurrected the 2008 interview in which Charlie Munger likened the state of accounting to a “sewer” and asserted that:

“a majority of the horrors we face would not have happened if the accounting profession were organized properly.”

And the ever-opinionated Dennis Howlett rang in (on the solstice itself):

“Francine, myself and others have for years been saying that audit is broken….(O)ne thing that any self respecting professional must look at and wonder. What the hell is going on with our profession?”

So what’s to make of this convergent outbursting? First, the chorus may be louder, but the lyrics are not new.

“Re:Balance” celebrates its third birthday this month – with my thanks and appreciation to all those who do me the privilege of their interest and involvement. From its earliest days, the message has been consistent; in its first month (here), I took up a reader’s question: “How much of this sub-prime thing is related to the accounting?”

As I put the answer then, and still today:

“Subprime and the credit market turmoil are all about the accounting, and nothing else. Fundamentally flawed assessments were made – whether out of venality or ignorance – about the quantification, timing and transferability of the risks associated with uniquely complex financial derivatives, and the collapse in their values as knowledge and experience eventually caught up.”

But attention goes back much further, to this blog’s antecedent, my column in the International Herald Tribune in Paris – where in April 2002, in my second piece,* I warned that, “what has been absent is a debate on how much longer the audit function, as it has been known for 150 years, can survive in its present form:”

“Companies will push the ‘rules’ of accounting beyond the edge. And unless the corporate audit changes in nature and in value, the Big Four auditing firms – down from the Big Eight in the last dozen years – will read their own obituaries well before another dozen.”

This is where Charlie Munger and those who focus their spleen only on the auditors go astray, and do real harm to the potential for constructive debate.

Munger has his history wrong, despite being closer than all of us to the Victorian-era birth of the audit function. Independent audit – voluntarily created by company owners -- was not born to bear a “public duty,” but acquired that appliqué in the decades after it saw off government take-over in England in the 1860’s and America in the 1930’s.

As a consequence, he gives an inappropriate pass to the central parties – the issuers and other players who really like the system as it is.  Which is understandable, because Munger as wheel-man for the legendary Warren Buffett is, unlike the average investor or shareholder, a member of that very circle who give no respect or regard to audited financial statements, precisely because of their ability to both grasp and exploit the inadequacies and obsolescence inherent in today’s model.

It’s as if – using Munger’s “sewer” analogy – blame for an antiquated and overflowing drainage system were inflicted not on the engineers and designers responsible for its shortcomings, or the politicians who refuse support for the renewal of the public works, but on the subterranean workers in boots and gloves, struggling in futility to shovel against a tide of dark and filthy muck.

As I put it three years ago:

“In the end, … the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable in a mirror held up to commercial society.

"Or as first put in the early 1970’s by cartoonist Walt Kelly’s swamp philosopher, Pogo the possum, “We have met the enemy, and he is us.”   

 

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---

* No available reference, I am sorry to say. The New York Times as sole owner of the IHT has managed not only to suck both the soul and the circulation out of that once-vibrant resource that served the overseas Anglo community so long and well, but also to consign its web archive to the same closed and inaccessible limbo to which the newspapers themselves are rapidly headed.

 

Disintegration of the Big Four Audit Firms? As They Tell the House of Lords, "We Don't See That on the Horizon"

The epitaph for the private delivery of audit services to the world’s large global companies was written in London on November 23.

During its generally amiable ninety-minute stumbling around the topic of auditor concentration – available here and observed on here and here -- the House of Lords Economic Affairs Committee queried the invited heads of the Big Four, “You do share the general unease about the fact that it could be Four coming down to Three?”

For the quartet’s response, the senior partner of Deloitte’s UK firm, John Connolly, contributed this entry to the lexicon of the self-deluded: “I don’t see that on the horizon at all.”

Which will go down next to the grim valedictory of Citigroup’s Chuck Prince in July 2007, that “as long as the music is playing . . .we’re still dancing,” only months before his forced departure, or – closer to home – PCAOB chairman William McDonough’s concession in September 2005 that among the regulators, “None of us has a clue what to do if one of the Big Four failed.”

Although memorable language would not be expected from a “numbers guy,” Mr. Connolly’s invocation of an empty horizon has real resonance.

Military comparisons are inevitable – and instructive. General Custer did not foresee danger from the invisible Indians. The American forces at Pearl Harbor were heedless of the approaching Japanese. And to Hitler, the beaches of Normandy were both well-defended and bare of Allied threat.

While in this decade’s uniquely impactful if unforeseen event, nineteen Saudi thugs with box cutters in their backpacks begat a world-wide season of terror, destruction and disruption, the effects of which have altered history.

As with these examples, and the grievous lessons that emerge only in the hindsight of the short-sighted, Mr. Connolly’s handicap is the limit on his vision – because a clear view of a blank horizon is of little value if the surveyed circumference extends no farther than arm’s-length.

I am indebted to my friend Shyam Sunder at the Yale School of Management for the Sanskrit folk tale of koopa mandooka – the “frog in the well”, which lives in blinkered comfort so long as confined within the boundaries of his closed little world.

But should he venture forth, the perils of the world outside are unknown. It may indeed be a paradise, full of succulent insects and comfortable lily pads and luscious companions with which the frog can disport and sire entire populations of little tadpoles.

Or, it may be a hell of deadly predators – voracious snakes and hawks and sharp-toothed fish. Or a searing desert beyond the fringes of the oasis, where a clueless frog will be pan-seared in minutes.

Unless informed and prepared, the frog in the well has no way to differentiate a prosperous future from one of mortal danger.

And the consequences of his ignorance are just as fatal as those of being wrong.

Here’s what the Big Four leaders might have said, in answer to the Lords’ call:

“We not only share your unease. We are terrified for the survival of our firms – not so much for our generation, who if fortunate may hope to ease soon into retirement, but for the future of a profession that depends for its sustainability on the talent and commitment of our younger personnel.

“Our ability to provide valuable assurance remains important to the capital markets. But it must evolve beyond the binary choice, whether or not to pronounce “true and fair” -- a choice exposed in the banking crisis by our delivery of unqualified audit reports on soon-to-fail institutions as not only unresponsive but affirmatively dangerous.

“Yet we are shackled to obsolete reporting by regulatory requirements confining us to an unhelpful commodity product. What is needed is no less than a fundamental re-structuring, under which:

• “Supplanting the current report form which no longer serves a useful purpose, we could tailor our reports to the real needs of particular users.

• “Our ability to deploy a full range of services would include access to the expertise of non-audit personnel to achieve more sophisticated performance and improved quality.

• “The interests of investors would be reasonably supported by government oversight, enforcement and protection such that our reporting would not create liability exposure of a magnitude that would destroy us.”

They might have said that. But they didn’t. For want of a vision extending to that far but visible horizon, a golden opportunity was allowed to pass. 

 

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The House of Lords Looks at the Role of Auditors: And Then Everyone Went for Tea

 Here’s a good way to increase the chances for satisfaction: start with very low expectations.

That was my approach, anyway, in dialing up the broadcast by Parliament TV of the House of Lords Economic Affairs Committee session of November 23, billed as a look at concentration in the audit market and the role of the auditors in the financial crisis -- here.

As a soporific, it was a decent substitute for televised football as a way to sleep off the after-effects of the Thanksgiving feast – watching the heads of the Big Four practices in the UK bat away slow-pitch questions that ranged from the naïve and misinformed to the incomprehensible.

Plainly, the intractable challenges to the viability of the large-company audit model are at no risk of being solved at the hands of the British legislators, whose depth of inquiry ran the gamut of complexity from A to B.

Examples:

• “Are you happy” with the degree of market concentration? Well, what’s not to like -- although it can hardly be admitted, when the Big Four control the entire large-company audit market with no prospect of competition.

• What about a threat to withdraw from the audit market? Oh, not us, your lordships – audit is at the very core of what we do!

• If that’s so, “are you uneasy” that the large firms would go from four to three?

• With a straight face, “we don’t see that on the horizon.” Of course not – while at the same time conceding that although the events of the credit crisis were “unprecedented,” there are “lessons to be learnt” for everyone.

Sometimes the unthinkable does happen – as the events of the last three years have made clear. So where was their lordships’ follow-up question: 

What would you do – what would any of us do – if despite your intentions, one of the firms incurred what was described with wonderful British euphemism as an “Andersen moment”?

And for this, there was no suggestion of an answer from either side of the tables. 

In the middle third of the proceedings, their nobilities were able to become better informed, if not wiser, as their invited guests gave a concise run-down of the irrelevance to audit concentration of a list of unachievable ideas -- namely:

• Break-up of the Big Four would add nothing to global-scale competition, since – against the breadth required because 80% of the revenue of FTSE 100 companies is generated outside the UK -- the resulting fragments would lack scale, coverage and investment capability.

• The current restriction on scope of services to audit clients – where last year no FTSE 100 company paid consulting fees to its auditor – is claimed to be working well: an assertion which, considering the unsolved nature of the survivability threat, means that if the current environment represents success, what would failure look like?

• The arguments for joint audits or mandatory rotation founder on the examples of degraded quality – the likes of Parmalat in Italy and BCCI in the UK itself.

• And the howler of the day: if audit is “implicitly a form of insurance,” why does that industry not ride to the rescue? – a proposition so discredited that even the committee chair hastened onward.

The hearing wound down to a clearly rehearsed and well-choreographed five pm break for tea, but not without an “Alice in Wonderland” go-round on the question of the auditors’ issuance of unqualified opinions in the months before the failures of such British institutions as Royal Bank of Scotland, HBOS and Northern Rock.

At the assertion that the auditors actually “performed well” in light of the complex events of 2007 and 2008, adjectives such as “astonishing” and “misleading” were tossed around both in the hearing and amongst subsequent commentators – here.

But why should anyone be surprised?

The pointed observation by one of the Big Four that the auditor does not assess the risk of a business, but renders a report in identical language, whether the leverage of the enterprise is 100 times or none at all – starkly contrasted with a plea from the questioners that an assessment of the “dangers" in a business is precisely, if simplistically, the assurance sought by a wishful user community.

In that context, the fact that the technical reporting requirements were satisfied, to avoid a going-concern qualification – if only through closed-door communications with the Bank of England and the Financial Services Authority – finally exposes the raw insufficiency of the current audit model.

As was equally the case in the 1980’s when the American auditors trailed the emerging catastrophe among the savings-and-loans, the profession lacks satisfactory tools when the regulatory regimes put them to the choice -- whether to qualify their opinions and generate a self-fulfilling prophecy of disaster, or to rationalize a demonstration of the emptiness of the report that constitutes their core product.     

If that much could be taken as established once for all, before everyone went off for tea, then unlike the case with most such posturing displays, the day was not a complete waste.

 

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The European Commission's Green Paper on Audit: After the Posturing, an EC Agenda for Real Progress

Say this for EC Internal Markets and Services Commissioner Michel Barnier’s call for public comments on his October 13 green paper, “Audit Policy: Lessons from the Crisis”:

No sooner had I sent in my own ill-tempered two euros worth – here – than my readership statistics showed a serious spike from addresses across the European Union. There’s real interest out there!

Having taken M Barnier to task, I was rightly challenged by readers to stop complaining and be constructive. So with a response deadline of December 8, this is to invite all those concurring that more is required from Brussels than a feckless and ill-informed exercise in redundancy, to register their views at the EU site – here.

The message is this:

All that needs be known is already at hand, to build the agenda for a really effective discussion on the re-engineering of a sustainable audit function to serve the world’s global-scale companies.

It would have these three components:

• Certain basic truths would be taken as established.

• Any further reference to the over-debated but impractical or unachievable “non-starters” would be barred.

• Focus would be on the handful of truly difficult, challenging questions – on which views would differ profoundly, but which are inescapably important to any progress.

In the first category, there may not be consensus on all details, but these propositions are basically beyond debate:

• Other than for purposes of statutory compliance, the standard one-page audit report no longer serves a function that justifies its cost to issuers or the exposure it imposes on auditors. Evolution to new forms of assurance is essential.

• The concentration of large-company audits among the Big Four is down to a critical minimum. A three-firm model is unworkable; failure of any one will disintegrate the entire structure.

• The organizational and capital structure of the Big Four leaves each one exposed to an unsustainable shock, from regulatory or law enforcement proceedings, or a civil litigation outcome in the $ 1 to $2 billion range.

• Regulators and politicians lack the vision, authority or means – separately or collectively – to rescue and sustain a large accounting firm once a shock tips it into a downward spiral.

In the second category, the catalog of “non-starters” includes:

• Liability “caps”, whether monetary limits or allocated percentages of responsibility.

• “Break-up” of the Big Four firms – an act of aggression having neither a rationale nor a basis in law. 

• The emergence of new global-scale entrants to the Big Four’s audit market, whether by merger, subsidy or organic growth. 

• The injection of outside investment into the Big Four’s capital structure, or alteration of existing ownership restraints.

• Mandatory auditor rotation or replacement.

• Contingency plans to replace the management of a firm under existential threat.

• Re-introduction of genuine forms of private insurance, by way of “catastrophe bonds” or otherwise.

Finally, to table a selection of the hard but unavoidable questions:

• What are the forms of assurance that issuers and users would actually value and pay for, and what structural changes are required – competitive, organizational, legislative and regulatory – to enable the evolution of a profession capable of meeting those needs?

• What form of regulatory oversight, inspection, enforcement and discipline would achieve a sustainable balance between investor support and protection and an audit function that is both disciplined and robust? In particular, what is the necessary form and amount of financial involvement of government – whether an investor protection fund, insurance of last resort or otherwise?

• Under a newly-structured audit delivery model, and with a comprehensively refreshed legislative mandate, what are the proper limits and guidelines on the scope of services deliverable to audit clients, and what re-visiting of concepts of auditor independence and conduct are indicated?

The envisioning of a symposium devoted to such an agenda – much less its convening – has yet to occur. Until it does, and the process moves on to real substance, the stability of the current audit model and the four firms providing most of its delivery are both at risk.

 

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The Big Four Accounting Firms Are Down to Critical Mass: Says the Financial Times - So It Must Be Official

In the country where the independent audit was invented, back in the Victorian era, the Lex column in the Financial Times has finally bought into one of the messages I have been flogging for years – here -- about the fragility of the global franchise of private-provided assurance -- here:

    The Big Four are down to critical mass.

It’s a subtle but real shift in language, away from the usual mushy euphemisms of the regulators, that another large firm failure “could disrupt the market” – as put in the vacuous prose of the EC’s recent Green Paper (see here).

As finally put forthrightly by the peach-colored London paper:

“(I)t is vital to work out how to deal with a repeat of the Arthur Andersen/Enron affair, because four is the minimum number of global accounting groups needed for a healthy industry. Many companies employ one firm for internal audits, another for the external audit and a third to offer consulting advice. The fourth player picks up the slack when a change is needed. Neither regulators nor customers would want to see the Big Four turn into the Big Three.” (emphasis added)

The discussion can now move on, if only by further small and agonizing steps. The next one, which the FT is on the very verge of taking, is the explicit realization that an unsustainable three-firm model will go into immediate collapse – not least because the survivors after the next disintegration, which will occur in another Enron-like spasm of recrimination and finger-pointing, will have neither the appetite nor the resources to pick up the wreckage.

The FT is close, but not there yet – because still fixated on either of two non-achievable approaches: 

“(I)f that happened, regulators would be left with two unappealing options. First is a forced split-up of the remaining accounting groups – a plan that would meet vehement opposition. Second, an ambitious smaller outfit could take over the ailing giant, roughly as Nomura took on Lehman Brothers’ European operations. But any non-Big Four auditor would face a huge challenge doing this, since these firms rarely work with big or even midsized companies; they audit only 5 per cent of the UK’s FTSE350.”

Been over this ground often before – here. Opposition aside, not only is there no legal authority anywhere for cleaving the Big Four into smaller bits. As a practical matter such a split would have to be done in all the major global financial jurisdictions – none of which has a regulator or legislature capable of conceiving such an idea alone, much less in concert. In any event, the result would only be a group of smaller and weaker firms, with unevenly distributed personnel, industry expertise and capacity for execution.

And if the FT’s writers would please do their sums, they could face the reality that – good as they may be, and that is not assured -- the smaller firms lack the scale, coverage and execution ability ever to play at the level of the world’s global-scale companies.

There are critics of the large accounting firms whose long-winded rants amount to an unqualified charge of auditor venality and corrupt client deference to the exclusion of public interest.

That is not a view I share, and not only because the perfervid rhetoric fails to offer constructive solutions. It’s because the inter-locking antagonisms that capture and paralyze the current audit structure also imprison a profession caught in an obsolete model of excessive and unmatchable expectations.   

The Lex conclusion isn’t wrong:

“There may be better ways to keep the auditing business competitive. Regulators and accountants should look for them now, rather than wait for the next scandal to force their hand.”

To be successful, that search will require escape from the “intellectual capture” that now prevents the entire interested community from conceiving solutions outside their limited vision.

And to be timely, it needs to start now.

 

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The EC's Green Paper, "Audit Policy: Lessons from the Crisis": The Bureaucrats Blow Another Chance

  

  "We've gotta do something, They"re serious this time.

    "You know what we gotta do. Toga party.

    "We're on double secret probation, whatever that is. We can't afford to have a toga party.

    "You guys up for a toga party?"

            -- "Animal House" -- 1978

  As the October 13 release of the European Commission’s Green Paper, “Audit Policy: Lessons from the Crisis” – here -- by rookie Internal Market and Services Commissioner Michel Barnier, illustrates:

Any newly-arrived bureaucrat, tempted to launch the machinery of inquiry, should first demonstrate the need for further admiration of an already tediously-explored agenda, and the vision and will to do more than re-plow the same sterile ground.

The naïve tone in which the Green Paper articulates the role of auditors, and the clueless innocence of its “questions,” make evident another major exercise in resource-wasting.

The vacuity of leadership vision and reasoning on the grave issue of the viability of global-scale audit has been on view for years -- here -- and continues in Brussels:

The Green Paper starts with the customarily limp and tedious observations – e.g., that audit “provides assurance on the veracity of the financial health of all companies,” and that “continuity in the provision of audit services to large companies is critical to financial stability.”

But this exercise in self-congratulatory amour-propre is empty. Its adherents have never known a world in which public company financial statements have not borne the commodity appliqué of the one-page standard auditor’s report. The alternative proposition, of life without the legal requirement of an audit – an obligation that survives only by force of law, not by market choice – has never been tested.

No less, the last of the weak and aging dinosaurs on their terminal descent into the tar pits no doubt had themselves persuaded of the vital centrality of their role and influence in their ecosystem -- just as the tidal wave of unstoppable evolution was gathering to wash them to oblivion.

Consider a few examples of the Green Paper’s tiresome re-cycling of old material (question numbers are kept; some wordings are streamlined):

Can smaller firms emerge to become viable participants in the large-company market segment (# 27):

Would someone please do the arithmetic? Assume the impossible – that all the small firms doing any public company audits were merged into a single practice. That unmanageable monstrosity would still be smaller than the smallest of the Big Four.

Just as the case has never been made that smaller firms can deliver competitively superior quality of service, their limitations of geographic scope, breadth of expertise and capacity for risk tolerance are disabling to the notion that a Big Fifth can be either grown or built. And their leaders willing to be candid will admit it.

Should alternative structures be explored to allow audit firms to raise capital from external sources (# 23):

A better question: did anyone with business literacy vet the Green Paper? The Big Four capital structures, with their modest partner investments and operations financed by their client receivables, do not need and could not deploy major outside capital if handed over on a platter (here). Rather, such funds would only be a honey pot to attract the further attention of potential litigants.

Would contingency plans, including “living wills,” address the systemic risk of a large-firm failure (# 31):

First advanced in 2008 as part of the cringe-worthy output of Treasury Secretary Paulson’s Advisory Committee on the Audit Profession, this trial balloon deflated without lift-off (here) – for the obvious reason as shown by Arthur Andersen’s rapid disintegration in 2002, that the death spiral of client and personnel flight, once started, is irreversible.

Should audit mandates be limited in time (# 18), or should rotation be mandatory (#29):

To this, the complete one-word answer has always been, “Italy.” The only country of any significance with mandatory auditor rotation – a land capable of producing neither enough children to sustain its population nor enough honest politicians to sustain functional government – did manage to produce the scandal of Parmalat – world-class malfeasance enabled by the rotation-inflicted division of audit responsibility between two firms. Enough said.

Are there benefits to joint audits or consortia including smaller firms (# 28):

The French structure of joint audits is argued for, but is profoundly unsatisfactory as a persuasive example – perpetrated as it is by the lobbying of the small firms’ nationalistic appeals to preserve a miniscule local slice of the world market.

The fanciful notion that minor rump-end participation in an otherwise global-scale audit engagement could give a small firm the muscle to supplant a failed Big Four firm is belied by the record: at present, every audit of the CAC 40 is led by a Big Four firm. If small-firm consortia were credible, there would already be at least one example in practice.  

Finally, should audit appointments and remuneration be managed by government (## 16-17):

Consider this long step down the short road to nationalized audit agencies. Nowhere else are markets for commodity products, other than audit reports, subject to such artificial constraints – whether auto manufacturers, retail bankers or espresso vendors.

Yet if viewed as a legitimate target for government take-over, audits performed by low-grade civil servants -- the only ones to find appeal in such a career post -- would descend in value and repute even further to the level of nationally-administered postal delivery, rail service and health care.

It’s all too depressing, to belabor these points yet again. But since Commissioner Barnier looks as green as his paper, the only hope is to administer sunlight and fertilizer and pray he ripens quickly.

 

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