Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations

“No such thing as a failed experiment …. only experiments with unexpected outcomes.”-- American engineer-architect R. Buckminster Fuller

 Is the Big Four’s concentrated control of large company audits a real problem? Persistent voices of concern and attention extend back at least to the 2006 study for the Financial Reporting Counsel (here), recently joined by global leadership of BDO and Grants (here and here).

If so, is there a credible case to incentivize their exchange of market dominance for liability limitations?

Those issues were addressed this month in a paper from the American Antitrust Institute – here. In an all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With pending claims totaling billions of dollars, the Big 4 audit firms face serious threats to their survival…. (L)iability exposure substantially exceeds the combined partner capital of the Big 4 firms… (They) contend that liability limits are necessary to prevent the loss of another Big 4 firm, which would throw the global financial system into chaos. (footnotes omitted)   

The AAI’s suggestion would be a legislated trade-off: “government incentives to break up the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned on a firm divesting itself of, say, 20% of its domestic revenue and the personnel serving the surrendered clients.

Can’t work – because of the many problems with the underlying but unachievable assumptions. 

But before getting there -- the AAI deserves credit at least for recognizing the completeness of the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250 million” (emphasis in original) – with even tighter limitations on auditor choice in such industries as metals and mining, energy, air transportation and financial services.

Start with the political unacceptability of liability capping at a level that can assure Big Four survival. I have spelled out before (here) the financial limits of the large firms’ private partnership structure and their membrane-thin working capital, under which they cannot withstand litigation shocks above the $1 - $2 billion range – a tiny fraction (by either amount or percentage) of the exposures in their pending lawsuit inventory.

As the AAI paper summarizes, critics of liability protection point to the firms’ average litigation payouts, as a percentage of revenues and as compared to the far larger total of alleged damages. They fail to recognize – as do the arguments for capping from the profession itself -- that averages are meaningless when the “outlier” of a single verdict, falling outside the misleading comfort zone of a bell-curve model, could and would be devastating.   

So: because American politics offers no cover for protection at those levels, that side of the proposed AAI bargain is no solution. What of the other side -- the plausibility of large-scale competitors emerging from the suggested divestiture program? The facts dictate otherwise.

First, an abundance of small practices already exist. Why they have not coalesced into global-scale practices is a long-familiar story of limited geographic scope, expertise, risk appetite and readiness to invest.

Second, the smaller sector does not inspire confidence in its strength or capacity for quality growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a deathwatch, facing the post-appeal enforceability of its $521 million jury verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins just received a seven-year prison sentence – now faces the fall-out of being fired by Koss, its public but family-dominated Milwaukee client, whose CFO managed for years to steal amounts in excess of the company’s total net revenue (on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a practical matter, how would global-scale competition emerge? If a Big Four firm were to hive off a small geography-based practice, that newcomer would suffer handicaps of capacity and expertise no different that those of the current smaller firms.  If a large firm were to shed an entire industry practice, no new competition is added to serve that industry. And if instead, it were to divide a viable large-scale practice, then each of the two sub-practices would be burdened with shortages of expertise, personnel and the capital strength necessary to build to scale and withstand their risks.

In summary, the AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in logic I described (here) in the comparison of a failing situation against an idealized state, without recognizing that the assumed achievement is impossible under real-world limits, flaws and constraints.

The large firms grew that way for service-based reasons. And dreams of expanding the population of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the AAI’s most seriously under-examined assumption is that the “catastrophic” disintegration of another Big Four firm “would throw the global financial system into chaos.”

Why so? To the contrary, if the now-standard auditors’ report were suddenly not to be obtainable from any source, who would miss it?

Regulators and politicians would have convulsions, to be sure. But as the financial crisis itself has shown, that is daily practice for office-holders in the hermetic confines of Washington and London and Brussels.  

Should the stock exchanges be closed, if a Big Four failure meant that one-quarter of the large listed companies lacked an audit report? Could those companies’ securities be barred from trading? Unthinkable. Out where capital really flows and trade is actually engaged, the world’s markets would shrug, start the process of designing new forms of assurance from a blank page, and move on.

And the splintered pieces of the former Big Four would provide ample building blocks for a new assurance structure – without, pace the AAI, any need or use for the unintended and unpredictable hazards of another failed experiment.

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

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

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

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

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

Auditors Missing in the Financial Crisis -- Readers Offer their Thoughts

To greet the new year, instead of a backwards look at a dreary 2009, this will revisit last month’s lively exchange, initiated by Francine McKenna’s provocative post of December 7, “They Weren’t There: Auditors and the Financial Crisis.” My response of December 13 is here, and hers of the 14^th is here.

Highly compressed, the gist of our mutual concern is, as Francine put it, “the auditors’ failure to be a force either before, during, or after the financial crisis.” The depressing explanation, said I, is that “their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism – having lost any value it may once have had, except for legally-required compliance.”

Our invitation to a conversation drew forth an exceptional level of reader interest and a cascade of comments. They ranged from the acute and perceptive to the callow and credulous – but all were seriously intended and deserve broader exposure and responses.

So picking a sample of some half dozen, and inviting the discussion to continue: 

PF noted to Francine that “the idea has been floated of having each exchange traded company purchase insurance against the financial impact of future restatements or fraud, but for that to work you would merely replace the auditors with the insurance industry, who would need to do their own “audits” before they would agree to underwrite such large risks.”

And David wrote similarly, that, “maybe each firm performing audits should have to put up a bond that would be available to creditors in the event of malpractice lawsuits. Let’s say that bond was equal to at least two years of the firm’s audit revenues. … You could even have an experience rate type of adjustment….”

Sorry – we've been there. If feasible, the idea of outside sureties would already be in place by now (here). The marketplace reality is that the insurance industry – which suffered massive losses on its coverage of the accountants during the savings & loan debacle of the 1980’s – learned enough to avoid a repetition.

It’s not just that the Big Four tetrapoly fail the essential tests of insurability, although they do – because of sector concentration, unpredictability of losses and inability to quantify exposures. It’s also that if any such “super-audits” actually existed, the auditors would surely be performing them already. The sad fact, instead, is that the poor profession is operating today to the best of its unfortunately limited capability.

On user expectations, Robert accurately observed that, “an audit is supposed to provide reasonable assurance, not absolute. An audit firm has many engagement teams…some good…some bad. The whole system can’t be vilified because of isolated events.”

“Vilified” – perhaps not. But it is precisely the isolated events – highly-consequential and destructive as they can be – that will bring down another large firm.

On this there are two points: First, because the accounting profession lacks an effective forum by which to scrutinize and learn from its failures and short-comings, it has been unable to avoid repeating the same performance deficiencies from one generation to the next. It's a failure in historical perspective, to miss the instructive comparisons between Parmalat, say, and Equity Funding – or between Satyam and ZZZBest.

Second, the community of financial statement users is unimpressed by the profession’s proclamations of its successes. Virtue is not preserved by an accumulated preponderance of generally good behavior – rather, it is dissipated and lost altogether by individually corrosive, culpable acts. For most of their life spans, John Edwards and Tiger Woods were credibly decent – as were Jimmy Cayne and Dick Fuld and even Conrad Black and Bernie Ebbers -- except for certain nasty instances when they were not.   

I had this note from JD: “The auditors were there and just got it wrong. They will feel the pain from this trying to defend the lawsuits. Whether they can be successfully sued is another matter. If one or more big firms fail as a result then so be it. In the long run there are enough other audit firms who will eventually step up.”

The problem is the last sentence. Under the large firms' presently dysfunctional model of litigation exposure, independence constraints, limited capital and concentration of resources and expertise, it is just not the case that alternative providers might emerge to replace a failed Big Four firm. That discussion can be expanded at greater length, and has been, but the only answer is "no way."

Francine had this interesting proposition from TT:  “the first firm to focus on quality, and to deploy and consistently follow standards that enforce quality regardless of other factors and metrics, will rise above the others. … But the sad fact is right now that the clients don’t perceive any differences between the firms, and it would take a significant difference to catch the clients’ attention.”

The standard audit report now being an undifferentiated commodity, TT’s point was answered by Geoff, who wrote that, “From 1933 until now, there hasn’t really been a evaluation of the core assumptions around audited financials. The requirements have evolved and become more detailed, stringent, as we go through the motions of continually fighting the last war. Add to it the institutionalization of the main players (audit firms, regulators, accounting designation self-regulatory bodies), and it’s easy to see how we’ve lost the plot.”

To conclude, the widespread inchoate desire for “something better” resounds in Esa’s plaintive note:

If you know of a better model that allows us to hold someone responsible for unforeseen future events, I’m all ears but that’s not a job I want.

A lot of people think the model is relevant though it certainly has flaws. The SEC, institutional investors, financial analysts, etc. all think the model requires tweaking but none suggest wholesale changes.

If fact, I haven’t heard anyone propose something that even comes close to a reasonable alternative that is actually feasible. If you have ideas on that front, please share them.

That’s an echo of the call from Francine and me. Progress will come neither from the self-interested parties' reticence to “suggest wholesale changes,” nor their continued pointing of fingers and weapons. Instead, as a first step at least, let the wide-open conversation continue.

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Invitation to a Conversation: If the Auditors Were Missing from the Financial Crisis -- Let's Ask Why

 

Last night I saw upon the stair

A little man who wasn’t there

He wasn’t there again today

Oh, how I wish he’d go away

 -- Hughes Mearns, 1899

 An under-appreciated power of the bloggers is the capacity for a two-way conversation, right out in full public view.

 That was my reaction, anyway, to Francine McKenna’s December 7 post, “They Weren’t There: Auditors and the Financial Crisis” – the gist of which is that the Big Four firms, who audited every one of the institutions complicit in the financial crisis, have been absent not only from visible influence on the catastrophe, but also from the post-mortem recriminations and accountability.

 Any regular reader here should also be subscribing to Re:The Auditors, where Francine airs a central theme:

“The auditors should have been there, as a last stop, where the buck should have stopped, as gatekeepers, watchdogs, advocates, and the last bastion of standards and expected values shareholders can look to.”

Here – in response to the always tart-tongued Francine -- is why the auditors weren’t there:

The simple if depressing reason is that their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism -- having lost any value it may once have had, except for legally-required compliance (here). 

If that single page disappeared from corporate annual reports, no honest user of financial information would admit to missing it. Nor, offered the choice, would any rational CFO pay the fees to obtain it.

There is plenty of assurance that users would value and pay for – that much is clear from the debates about the largely unrealized usefulness of reports on governance, sustainability and intangible assets outside the scope of historical cost-based reporting (for specifics, this column of mine goes back to April 2006).

But not in the current liability environment, where the large accounting firms are captive to their business model and paralyzed from innovation by their twinned lack of vision and influence.

On the other side, the regulators’ mantra that “audits are essential” is no more than the unexamined and self-reflexive assumption that audit reports will simply and always be there – like air or water or electricity. Whereas, if another fragile Big Four firm does trip into disintegration, nothing within the capacity of any regulator on earth will be able to put the shattered networks back together again, or compel the delivery of audits when there is nobody left to perform them.

If there is to be an adult conversation around this issue -- and along with Francine, there are real participants -- for general examples, Tom Selling's stimulating Accounting Onion, Dennis Howlett's acerbic AccMan, or Richard Murphy's Tax Research UK -- there are at least three other chapters to be aired, at whatever length is needed for credibility:

First, it is past time to put final closure to the talk of unachievable structural “solutions” to the Big Four’s complete dominance of large-company global audits. None of these can happen – as sketched out here – whether it be growth to competitive scale of a Five or Six, break-ups to restore a new but even further weakened Eight, mandatory rotation, new insurance or outside capital, liability limitations, or government take-over of the entire function.

Second, the financial structure of the private Big Four partnerships must be recognized as too weak and limited to sustain their current exposure -- here. Unlike the banks, their franchise is not “too big to fail” – the question is whether there is a better cliché than “too weak to survive.”

Finally, as a message to the Big Four leadership who have no choice but to get out in front, the private sector must acknowledge that no help will be forthcoming from government. Legislators – whose essential DNA bars them from any activity other than belated over-reaction – cannot be counted on for anything other than interference (here).

Worse, coordinated regulatory strategies are impossible at the global level – witness the floundering over GAAP / IFRS convergence as a simple example – while in the United States, a populist-oriented administration is not about to provide relief to a white-collar profession perceived to be overpaid and under-performing.

So there is no falling back upon the fallacious assumption that “’they’ won’t let another firm fail.” There is no “they” – no regulator or politician with the vision, interest or authority to prevent a debacle.

Francine’s massive army of readers is a potential force to be reckoned with – and has plenty at stake, whether as practitioners with careers-at-risk or users in search of better quality financial information. 

With their engagement, the evolution to a sustainable, achievable new model of reporting and assurance is possible – however unlikely, absent real commitment to a fresh and holistic approach.

But the dialog has to move beyond whiny finger-pointing, and the simplistic recitation of unrealistic “solutions.

And the sooner, the better.  

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Re-Posting -- Internal Control Reports Under Sarbanes-Oxley: Hazards Out of Washington

In my first job in journalism, back on a small-town newspaper, the last critical deadline risk was a break-down of our creaky old press. Now it's that the elves of the internet somehow got Monday's post out via Twitter and my news groups, but failed to feed it to e-mail subscribers.

This re-posting is with my appreciation to all, and my apologies for either the delay or the duplication.

What’s in store for reporting on internal controls under the Sarbanes-Oxley law? The most important Washington development was not last week’s legislative merry-go-round over possible small-company exemption.

As discussed here, the SEC had earlier pushed back its deadline under Section 404(b) for auditor reports. Impelled by White House Chief of Staff Raum Emanuel, the House Financial Services Committee responded with approval of a permanent exemption, as proposed by Representatives Scott Garrett (R-NJ) and John Adler (D-NJ) (teed up in Edith Orenstein’s post of November 4 on her FEI Blog).

What may yet emerge from Congress is anybody’s guess – considering the opposition of Committee Chairman Barney Frank (D-Mass) and SEC Chairman Mary Schapiro and Commission Luis Aguilar. Their view is championed by Floyd Norris of the New York Times, quoting ex-SEC chief Arthur Levitt – here – in whose hyperbolic antagonism the climb-down on Section 404 would rank with repeal of the Bill of Rights or perhaps the Ten Commandments.  

Much more ominous, across the country in Seattle, was the October 27 opinion and order of federal district judge Marsha Pechman. As discussed by Kevin LaCroix (D&O Diary), Judge Pechman has sustained most of the shareholders’ class lawsuit against fallen home lending giant Washington Mutual, along with its senior executives and Deloitte, its auditors.

The case is based not only on the usual array of claimed false financial and other statements, but on WaMu’s allegedly defective internal controls and the opinions of management and the auditors – claims that WaMu “misrepresented the state of its internal controls, which were weakened in order to facilitate WaMu’s reckless lending practice,” and that Deloitte “made the false and misleading statement that its internal control reports were audited ‘in accordance with the PCAOB’s standards’.”

From the very passage of Sarbanes-Oxley in 2002, its requirement for opinions on internal controls has been an under-appreciated time bomb. Under Judge Pechman’s Order, the fuse is now lit, live and sparkling.

WaMu presents a major survivability hazard for Deloitte -- and by extension, for the viability of the entire big-firm assurance franchise. The investor claims involve securities totaling more than $ 4 billion -- well above the destruction threshold of Deloitte or any of the large accounting firms (see here).

And the plaintiffs are represented by the veteran law firm of Bernstein Litowitz Berger & Grossman – reported to have achieved five of the ten largest securities fraud recoveries in history, and to have collected over $ 20 billion on behalf of investors – here – thus no strangers to the extraction of serious amounts from their adversaries.

In the early years of Sarbanes-Oxley, while the accounting firms were reaping major revenues from their work on big-client compliance, two topics largely dominated the discourse: whether the cost was actually achieving any real value to the capital markets, and whether there could be a screwing down of the escalated fee increases felt to be windfalls to the large firms.

Two other themes were either lost or absent in the discussion. The first was that Section 404 reports and opinions comprised a new class of publicly-accessible statements on which investors might claim reliance to their detriment – no less than traditional financial statements and audit reports – a chicken now come home to roost in Seattle.

The second was the ultimate but eventual day of reckoning, with the certain arrival of large internal control failures. There a crucial mis-alignment lay concealed: the accounting profession’s cash-based business model involves immediate profit distribution to reward current partners, while the related litigation burden lies inchoate and deferred until inflicted years later on succeeding generations.

This kind of disconnect is broadly familiar:

• ·      The immediate benefits of large public works are consistently over-stated, for failure to recognize, for example, the future radioactive waste disposal costs of a de-commissioned nuclear plant, or the environmental disaster of a strip mine or a silted-up hydroelectric project.
• ·      Only now are the re-cycling impacts of consumer goods becoming visible – whether in the recoverability of scrap auto components or the packaging of home appliances or the extraction of metals and chemicals from old computers and refrigerators.
  
• ·      Closer to home, it’s a fair bet that the strategists in the law and accounting firms responsible for the tax shelter strategies so aggressively sold to their clients a decade ago did not include in their business plans the costs of their legal defenses, criminal trials, fines and civil settlements.
• ·      And nowhere is the timing mis-match more acute than in the legislative arena, where the sleight-of-hand calculations for health reform proposals or military hardware procurement or tax code revisions are fanciful exercises in advocacy.

In the same way, it is no small understatement that the profitability of the Big Four’s Sarbanes-Oxley compliance work would have been unpleasantly re-calculated, when the law was enacted in 2002, if future litigation exposures running into WaMu’s billions had been taken into account.

So concerning the yes-or-no desirability of Sarbanes-Oxley 404 for smaller companies, there is this interesting question:

With the potentially catastrophic impact of a WaMu trial now pending, and claims among the roster of failed financial institutions lurking in the background – why would a young partner in a Big Four firm think that more such expanded Sarbanes-Oxley work is a good idea?

Those who may think so are invited to explain why – especially to their dependents and their creditors.  

 

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Sarbanes-Oxley 404(b): Auditors' Reports on Internal Controls -- A Shot in the Arm, or a Poke in the Behind?

What’s to be made of the US Securities and Exchange Commission’s grant, on October 2, of yet another extension of its deadline for small companies to have reports on their internal controls by their independent auditors? (See Edith Orenstein’s FEI Blog – here and here.)

As the autumnal season for influenza raises alarmist cries of epidemic, the comparison with an improved but experimental vaccine seems apt.

The mandate of section 404(b) of the Sarbanes-Oxley law is criticized as a boondoggle for the accounting firms, or worse, by Tom Selling (The Accounting Onion), and the whole issue of auditors' work on controls is thoroughly raked over by Francine McKenna (Re:The Auditors). And there were short-lived legislative moves in Washington to extend or make permanent the small-company compliance exemption -- see the October 30 Compliance Week.

In this context, there is much to contemplate.

To start – just as with the question whether to submit to a shot against uncertain exposure to a new type of swine flu – is there any real upside?

Veteran readers here know my deeply skeptical view that Sarbox was never more than a knee-jerk political feel-good exercise – going back to my July 20, 2002 column in the International Herald Tribune: “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

In the general population, most will never even catch the flu at all, or at worst will spend a few days of bed-ridden discomfort. Most public companies, likewise, operate honestly and with generally satisfactory controls, or require only modest treatment of their symptoms in order to return to good corporate health.

There are sectors at special risk, to be sure. With new vaccines, officials struggle to identify and set priorities and to deliver to the right targets – the elderly, the infirm, the weakened. That’s tough enough, for expert epidemiologists and public health professionals. Errors and oversights are unavoidable, as with any system under human design, and there will be casualties.

No less, the episodic outbreak of corporate malfeasance is unpreventable, and will strike a percentage of the most exposed. But no regulatory system yet conceived has been able to identify the “at risk” targets or find a way to avoid a non-zero victim count.

Secondly, there are the false negatives. Just as no vaccine provides protection against all strains, especially the newly emergent and opportunistic, the large-company experience with Section 404 has shown that Sarbanes-Oxley has failed to inoculate the corporate world against continued out-breaks of business dishonesty.

Attempts to legislate virtue have been no more effective than a mandatory vaccination program – whether among foreign companies with US-traded securities (Parmalat and Satyam), or individual perpetrators (the convicted Bernie Madoff, the accused Alan Stanford, and the recently-charged Raj Rajaratnam), or the long list of fallen financial institutions (Bear, Citi, Lehman, AIG, Merrill, etc.) whose cleanly-reported controls did not protect them from the fatal infection of the credit market collapse.

Third and most pernicious, there are the inevitable side effects.

It is mis-directed and erroneous to ask whether corporate behavior has improved since the post-Enron legislative spasm of 2002. Rather, Sarbox has never been fairly measured for its negatives – extravagant costs, severe disruption of the auditor-client dialog and relationship, and diminution of real value contributed by the assurance process. Just as most flu victims recover full good health, whether treated or not, the proper question is how the side effects of Sarbox weigh against the evolved corporate governance and controls that would have emerged in the normal cycle, had the law never been enacted at all.

Discussion of the Sarbox cost-benefit analysis typically omits recognition that the equivalent of “good health” practices was always in place. Just as preventive hand-washing and use of Kleenex will fend off most routine contagions, the prohibitions on false statements to investors under the American securities laws have a long tradition of deterrence – imperfect, to be sure, but nothing is. So the proper question is whether imposition of a universal requirement for additional measures under Sarbox could justifiably alter the prevention calculus for the better.

To conclude -- leave for another day, and soon, scrutiny of the potentially devastating litigation exposures run by small companies and their auditors when the next round of control failures show up in a renewed wave of investor litigation.

For now, compare with a health-delivery marketplace where individual choice still counts. Conscientious consumers can weigh the potential benefits of an experimental new vaccine. They can consider the risks of side effects and possible false comforts, absorb the publicity from a profit-driven drug industry, and decide accordingly.

With Sarbox 404(b), by contrast, unless a re-evaluation occurs while this latest deadline extension is pending, small listed companies will have no choice but to bend over and offer a fat and juicy target – to be stuck by a needle-wielding bureaucrat with the fear-inducing cry, “I’m from the SEC, and this shot is for your own good.”

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On the Calendar: What Every Auditor Should Know About Litigation

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

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

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

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

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

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Global Convergence of Accounting Standards? In Whose Lifetime?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

Let me know if you think so.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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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Which Large Accounting Firm Will Be "Next to Fail"? It's the Wrong Question

When was there ever so concentrated a burst of public speculation on “which Big 4 audit firm is the next to fail”?

Within a single week, Accountancy Age predicted it would be Ernst & Young; in the blogosphere, Francine McKenna’s wager with Dennis Howlett fingered her ex-employer and bête noire, PwC; and ProPublica reached into the remains of the second tier to round on McGladrey and BDO.

All for very serious reasons, ample to cause sleepless nights among the profession’s leaders. But the voyeuristic speculation as to “which one” is a pointless and mis-directed exercise, because each of these firms – but also Deloitte and KPMG, and Grants too, for good measure – faces multiple overhanging threats on a mortal scale.

All the chambers are loaded in this losers’ game of Russian roulette. So it is an unanswerable question, where the weapon may be pointing when the hammer falls next. It’s also an irrelevant query, too – because it depends entirely on the judges’ docket management on Parmalat, Satyam, New Century, AIG, Bankest, Refco, Sentinel, the Madoff feeders and all the other ticking time bombs.

Instead, the real question should be, “What next?”

On this, for grown-up dialog to occur, two fundamental misconceptions – both lurking in the Accountancy Age article – have to be killed off, once-for-all:

The first is that the large firms’ survival will somehow be assured by government, on the assertion that global-scale companies “will invariably have a legal requirement for an audit.”

If there is any logic here, it is seriously inverted. The regulators long ago conceded that they would be powerless to stop the disintegration of a large firm that reached a tipping point – here and here. Further, when that next step takes down the other three, and unravels the entire suppliers’ market, legislative mandates that there be audits would be as futile as a requirement that all trains be hauled by steam locomotives. No more suppliers: no delivery. Period.

The second fallacy, conspicuous even in an article that displays a truly stunning lack of comprehension of the profession’s structural issues, is that a Big Three would survive the loss of a fourth.

Won’t happen. The uneven concentrations of industry expertise around the world’s large economies, the politically-imposed constraints on auditor choice, and the post-Andersen fragility of the international networks are alone sufficient to show that the Big Four are already down to an irreducible tipping point. One more, and they all go.

While no insider will say so in public, senior risk managers acknowledge that in the coming turmoil of another Big Four failure, the prospect that three survivors would stay in today’s business by accepting further concentration of exposure and liability will be untenable.

That a fundamental re-structuring of the profession will occur is beyond debate – and is nothing new – although answers will only lie in the readiness of all interested parties to get past the posturing to offer constructive, achievable solutions.

Trouble is, none of the critics have either the vision or the authority to lead. There is no available government intervention, to “save” a privately-capitalized Big Four partnership once slipped into a death spiral – here. Nor can the large firms’ collective survival be enabled by statutory requirements that there be audits; if a firm goes down and takes the others, it is as futile as King Canute’s attempt to order the tides, to require delivery of an audit report when the providers are all out of business.

The only alternative to a highly-disruptive disintegration of the large firm networks – and a long shot wager indeed, requiring the most wild optimism to imagine – would be the emergence of Big Four leadership prepared to engage, for the sake of their future, in the “creative destruction” brought forward in 1942 by economist Joseph Schumpeter:

•    To forswear the currently outmoded auditors’ report, which provides no value to the market and is toxic to the sustainability of the firms’ business model.

•    To cut to the heart of the critics’ animosity, by the deep finesse of voluntarily turning the task of issuing low-value “compliance assurance” over to nationalized agencies.

•    To allow the capital and investor markets to ascribe to “compliance audits,” performed by huge cadres of conscripted civil servants, the nominal value they would deserve.

•    To empower the surviving firms to invent, sell and deliver new forms of assurance that companies will buy, and the markets will pay for, under sustainable limits on liability and free of the life-threatening legal exposures as wielded by the class action plaintiffs.

•    To break the antiquated shackles of the compliance-driven limitations of “independence,” so as to build or acquire whatever professional services capabilities may be congruent with the new forms of assurance – whether in systems or technology consulting, finance, law or otherwise.

Starting down such a road would require envisioning an entirely new set of directions for the profession – beginning with the acknowledgment that the current race is going around a one-way track to a dead end. 

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Once and Future Accounting Schemes -- What Will They Think Up Next?

       

"Everything old is new again ...."
                -- Peter Allen

To pull off the next large accounting scam – or, more virtuously, to try to prevent it – where would we look?

This always-pertinent question has global dimensions, with criminal charges now lodged against two Price Waterhouse partners in India – see here – for their alleged complicity in the fraud perpetrated at Satyam Computer Services Ltd. under the leadership of CEO Ramalinga Raju.

Those inclined to heed memory and history as guides for the future will find familiar the recited bad deeds by which the Satyam accused are now answerable to the Indian courts:

• Bogus invoices for customer work never performed lay at the heart of the mid-‘80’s house of cards known as ZZZZ Best.
• Inflated rolls of non-existent employees echo the ledgers of fictitious insureds a decade earlier at Los Angeles-based Equity Funding.
• Shadow businesses and opaque investments recall the undrillable pools of petroleum, said to lie deep under the Canadian Arctic, sold as snake oil in the 1960’s by Bernie Cornfeld in the original version of Fund of Funds.

In a world of borderless impacts, and with the certainty that details of the Satyam criminal file will now implicate the defensibility of the investor lawsuits lodged in the United States as well as in India, it’s well to ask what new risks lie over the next hill.

Especially since, as similarly structured schemes have kept recurring with dreary regularity, decade after decade, the learning capacity of the financial gate-keepers is slight enough in fighting the last war, let alone to anticipate or prevent the next.

A starting point will be the predictable re-emergence of another rogue trader – almost routinely expected if still highly impactful – the next generation’s reincarnation of Nick Leeson at Barings or Yasuo Hamanaka at Sumitomo or Jerôme Kerviel at Société Générale.

But it’s also back to basics, in a world said to be reverting to older styles of banking and finance. In the recent era of exotic financial derivatives and black-box valuation models, the pervasive separation of deal-doing incentives from underlying transaction risks provide illusory and ultimately disastrous. Looking ahead, it can be anticipated that the next generation of white-collar schemers will unsheathe the simpler tools that have served so effectively throughout the past to entice the investors and evade the auditors.

Old memories may still spark, for example, to recall the 1960’s tanks full of “vegetable oil” in the meadows of New Jersey: collateral for the negotiable warehouse receipts issued by American Express, but actually nothing but water – a scheme that succeeded because the auditors looked from the top of the tanks at the thin layer of oil on the surface, rather than taking taps from the bottom.

Or the herds of ghost cattle, sold in fractional interests to urban investors: the livestock numbers were inflated by repeatedly cycling the same calves through the counting chutes – under the noses of the city-based audit staff who failed to prevent double-counting by the simple control of a chalk-stick mark on the forehead of each animal as it passed by.

Or the heavy-duty oil-field trucks comprising salable equipment portfolios: sensibly counted as they were scheduled through their repair and maintenance depots -- except that each one slipped past the auditors multiple times by the simple expedient of driving behind the repair shed to swap the identifying bar code on its engine block.

Or – to tie off a list that could otherwise go on a while – the allocation to investors of interests in a giant hill of Latin American coffee beans: except that under a thin layer of the real thing, the mound consisted of sand and bales of hay – undetected by the auditors too fastidious or pressed for time to drill or dig deeply enough to the core to get a legitimate sample.

All real stories – none of them all that original. But any of them will likely show up again soon, as timeless devices used to inflate the performance of money-gathering institutions basing their business on asset-based transactions.

Let the gate-keepers be warned – and the future perpetrators too. But only if the lessons of the past are learnable.     

Drop me a note if you have a candidate for an industry or a practice having special exposure. As a teaser -- I will soon take a specific look at a particular sector where I would see this aspect of risk to be both newly emergent and especially acute.

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"Where were the Auditors?" In this Crisis, Nobody Asks - Because Nobody Cares

In the rural America of my youth, the ultimate symbol for feckless optimism was the farm boy discovered in the barn early on Christmas morning, digging in the manure pile, crying out that, “With all this horse-shit around, there must be a pony under here somewhere.”

My series of meetings last week started with the investment officer of a large hedge fund. Over an extremely dour martini he volunteered his list of those responsible for the nightmares still spreading from the credit markets through the entire world economy:

•    Homebuyers whose aspirations overreached their ability to pay.
•    Mortgage lenders piling up immediate fees for unsustainably aggressive products with neither rational underwriting nor retained risk.
•    Bankers made rich beyond reason by packaging subprime mortgages and other exotic products into slices too complex and obscure to be comprehensible.
•    Ratings agencies whose imprimatur was the key to worldwide distribution of these previously unknown instruments.
•    Investors so graspingly eager that they bought uncritically into the triplet myths of a never-ending real estate boom, ring-fenced exposures and fail-safe yields.
•    And the regulators and politicians whose laisser-faire enabled the entire fiasco.

I waited for him to include the auditors – scapegoats inevitably tagged for blame in every scandal’s aftermath. And waited.

And was still waiting, later that day, when my other friend the insurance executive laid out the precisely identical cast of miscreants  -- with the same unexpected omission.    

In this non-scientific sample, despite the raging furor over accounting standards for fair value and the world-wide lobbying for relief from mark-to-market requirements, nobody was pressing the question, “Where were the auditors?”

There will be days of reckoning to be sure: the Big Four all face new mega-claims -- gratuitous to recite, because taken from the familiar roster of failed financial institutions.

But instead of hauling the auditors into their hearing rooms, the grand-standing politicians are making sport with such fallen executives as Richard Fuld of Lehman and Martin Sullivan and Robert Willumstad of AIG.

My two highly knowledgeable friends both distinguish earlier waves of corporate malfeasance: In this era of turmoil so extensive and widely supported, the accountants didn’t cause the problems in the first place, and in the second, they’re not important or influential enough to provide a fix. 

The value to users of large-company audits began to deflate in earnest in the 1980’s, during the piratical recapitalization of corporate America led by the likes of Ivan Boesky, Michael Milken and Henry Kravis. An unobserved non-event back then, when the predators would lose a deal and lick their wounds and go on to the next deal, was the total absence of claims against auditors.

The simple reason was that no disappointed raider could be bothered to assert reliance on audited financial statements – no such claim would have been credible, when those reports attracted only yawns in the due diligence rooms before being tossed aside.

The trend continued at century’s turn, during the dot-com boom, when stock prices became completely unhinged from traditional financial reporting – when price/earnings ratios were irrelevant to IPO’s and hot after-markets, because flotations did not even require revenues, much less the rigor of real earnings.   

And today, unbidden, the accountants are unheard in the public debates on the causes, accountability and solutions for the credit market debacle. Even on fair value, their predictably rational and sensible position (here) puts them, as customary, on the opposite and futile political side from the forces of influence – unable to stop or even deflect the overwhelming rush to satisfy the world’s bankers specially pleading for the authority to “mark-to-fantasy”.

There are ominous long-term implications in the accountants’ slide to marginalization. Balance sheets loaded with toxic assets that are “marked-to-whatever” will suffer for credibility under the noses of skeptical investors, who know full well that the pile of manure is still fermenting somewhere.

In the same way, the fundamental issue of trustworthiness – on which the entire value of the auditors’ franchise perilously rests – is put under scrutiny when they are effectively sidelined for want of influence and capacity to persuade.

Which marks a shift in the debate on the continuing viability of the profession’s future. Whether the Big Four are “too big to fail” or “too fragile to survive,” it increasingly appears that – if the auditors are so insignificant that they are being ignored, even to be criticized -- then they are “too irrelevant to matter.”

Sad as it is, that bodes ill.

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