Re:Balance -- Jim Peterson

Federal Charters for Accounting Firms -- A Blank Page Approach

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

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

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

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

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

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

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

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

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

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

Collateral benefits to federal “chartering” abound:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Independent Auditors' Reports -- If They're Obsolete, What's the Alternative?

On March 27 I posted an earlier column from the IHT -- here -- which suggested that the concept of auditor independence is providing no value to either auditors or users of financial information, but is worthy only to be scrapped. The follow-up column summarized broad reader concurrence, and opened the question what should replace the now-obsolete one page report.

Auditing on the Brink

Originally published in the International Herald Tribune on April 8, 2006

I recently put forth the argument that, because of the doubtful prospects for survival of the global accounting firms, the rules of auditor independence should be scrapped and the auditors freed to solicit whatever business they liked.

I expected to be treated as if I had impugned the combined athletic divinity of Pelé, Joe DiMaggio and Tiger Woods. But no, the responses were both positive and supportive. From a reader in Belgium, "Auditor independence is not only killing knowledge, it is killing business." From France, "Leaving ethics to the auditors' conscience should suffice."

To go the next step, a comment from Britain - "the key issues are the integrity of the auditor and the transparency and completeness of the audit conclusions" - pairs up with the poignant view of a retired partner in a Big Four global accounting firm that the code, rules and constraints of independence are worth preserving as "the very essence of what the auditors are selling."

But these views lie at the heart of the problem, which is the dirty little secret of the auditing game: The auditors' core product - the one- page report with its opinion that financial statements are fairly stated and free of material error - is providing no value to investors or other users. No one reads it or pays attention to it. If not for the deeply embedded compliance requirements of the securities regulators, no rational chief financial officer would engage outside auditors to produce it.

The presumptive value of the independent audit report, which has come down to us from the Victorian era, has been one of those Jeffersonian verities - manifest, unexamined and immune from critical challenge. But the evidence of its irrelevance is compelling.

The most sophisticated investors have long since stopped relying on audit reports. This is shown by the fact that, in the past 20 years, no lawsuits against auditors have been brought by the really smart guys - the venture capitalists, the managers of private equity or the financiers of leveraged recapitalizations. These users look at the cover of an annual report, yawn, and go about their real diligence.

Less sophisticated investors also ignore auditor reports, as shown by the complete disconnection, during the bubble years of the 1990s, between share values and audited financial results. Soaring share prices were supported by neither assets nor earnings under generally accepted accounting principles - nor, in time, even by revenue. The analysts herded their clients, and each other, down roads paved with airy business plans, empty promises and inflated expectations. At the point of collapse, the audit report provided only a ticket to the courthouse.

That audit work of real value could be delivered to users who would be prepared to pay handsomely is a proposition that deserves to be tested.

Here, off the top of my head, are examples of special audit reports that a savvy post-Enron chief financial officer would commission:

Focused attention, after Shell, on the procedures for evaluating petroleum reserves and the results of that evaluation.

Line-by-line scrutiny, after Parmalat and Bawag PSK, on the operations of Cayman Islands subsidiaries and Caribbean trading partners.

Detailed portfolio scrutiny, after Fannie Mae and American International Group, on complex financial instruments like derivatives and finite insurance.

Investment banks and investors in search of best-in-class assurance would line up for such information, and on contract terms that would eliminate ruinous auditor liability. And they would not give a tinker's damn for auditor independence. Their focus, and expectation, would be top qualifications and good-faith performance.

But not today. The combination of ossified compliance requirements, obsolete practice restrictions and runaway liability mean that auditors today could not sell such products even if they wanted to.

Those who pine for the days when an auditor earned broad professional respect by detailed examinations of the distinct items in corporate accounts are entitled to mourn. What they cannot avoid, however, even through the best-intentioned sentimental wishes, is the inevitable evolution that has taken the profession to the brink.

Valuable forms of financial statement assurance remain to be created and brought to market. What form the profession will take that will do so remains a vital question. The only certainty is that the structure will be different from the one that exists today.

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

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

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

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

Setting Free the Auditors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Société Générale’s 2007 Annual Report – Jérôme Kerviel Is So Last Year

The recurring claim of French exceptionalism got a big boost early this month – at a price. Société Générale asserted that the only fair way to report its loss of € 4.9 billion, inflicted in January by junior trader Jérôme Kerviel, was as an event occurring in 2007.

Deep down in footnote 40 of SocGen’s massive annual report – to get the English version -- here – ou bien la VO Française ici – the bank discloses that Kerviel was in a net positive position of € 1.471 billion as of the end of 2007. His blow-up came on January 18, and the unwinding losses in the following days came to an eventual € 6.382 billion.

Over-riding the compelling guidance of the International Accounting Standards Board, that would book the effects of Kerviel’s mischief as they fell, would be rare enough under the UK’s high-level “true and fair view” rubric, much less under the American guidance of “present fairly in accordance with generally accepted accounting principles.”

But that didn’t stop the French bank – supported by its national banking and securities market supervisors, as well as the two Big Four accounting firms -- Ernst & Young and Deloitte & Touche -- who share responsibility for its audit.

There is at least behavioral history on the French side: for years the European practice of booking the effect of deliberate errors in the year of discovery rather than in the year of perpetration has avoided the litigation hazard of the American requirement to re-state erroneous financial statements for prior years.

And on the recent and highly political side, the French have been vocal and steadfast in resisting the international standard for marking financial derivatives to market – the infamous IAS 39 – arguing the difficulty of valuation models other than historical cost but also conveniently retaining the flexibility of corporate management to time their recording of results to suit their discretion.

SocGen’s tone-deaf approach starts with its footnote description of Kerviel’s trading “plain vanilla” financial instruments – a colloquialism lacking both a usable French translation and a common understanding in the industry. Nor is there any positive spin to the term, since the more ordinary Kerviel’s scope and job description, presumably the more effective SocGen’s oversight and control of his desk should have been.

As I am told by the technical accountancy wonks, SocGen may – just barely – have a straight-faced justification, that its year-end balance sheet should reflect the € 4.9 billion body blow that struck only three weeks later.

Fair enough, on a casual first glance. But the argument for evading a well-known body of international standards, under an exception so obscure and elastic that prior examples are virtually unknown, fails on three grounds – technical, strategic and political.

First, on the technical side. Moving around Kerviel’s impact cannot lessen its prominence or significance. As a post-closing event it is comprehensively discussed for three pages in the SocGen report. A pro forma balance sheet presentation right there would do as much for disclosure as the roll-back could.   

Even if it can be done, in other words, doesn’t mean that it should be.

Strategically, then, what’s the point? The known facts are so notorious that no one will be diverted or misled. Whether CEO Daniel Bouton survives – whether the bank itself survives – or how much the bank will ultimately pay out to the shareholders who are now at the courthouses with claims that the bank was running a “culture of risk” – none of these will be affected by the choice of years. So if SocGen can achieve no good for itself, what constructive purpose could there be in adopting a lightning-rod position?

And politically, the bank has succeeded only in setting back the global arguments for international accounting convergence, harmonization and improvement. If a “fair reporting” excuse can be made for Kerviel, there is no intellectually defensible line-drawing guidance by which investors can anticipate where the next similar exception will be invoked.

The size of the event can’t be a factor. A knock of € 4.9 billion is big, to be sure, but consistency in the reporting of small things is of little use if it’s the really worrisome big problems that qualify for revision and exception.

And with a French tradition to favor management’s opportunity to manage the timing of bad news, agreed by the supporting players, predictability of reporting at the global level is out the window.

So vive la difference – but let it be kept to matters of local impact only. 

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

Saying the Unthinkable

Published in the IHT on November 10, 2007

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Law of Diminishing Returns

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Don't hold your breath.

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

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

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

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

The Accountants' Own Search to Establish Real Value

Accountants and Auditors: Time to Part Company?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The prospects of change are dire, of course.

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

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

Blackstone's Pre-IPO Accounting

Hindsight is so wonderful. A week after this column ran in the IHT, Blackstone pulled back from the proposed accounting treatment discussed here. In the circumstances it would be a shame to go back and re-edit the verb tenses.

It also brought its offering at $31, into the teeth of the subprime mortgage meltdown, and saw its price sag immediately below $22. For the company’s principals whose net worth expansion is measured in units with capital “B’”, little sympathy is indicated.

Private Equity Discovers the Value of Myth

Originally published in the International Herald Tribune on May 25, 2007

A timeless but troubling story lurks in the plans of Blackstone Group, the private equity giant, to raise $4 billion through an initial public offering.

Blackstone proposes, through the use of options accounting, to book as immediate profits the gains it estimates that will presumably be made once its transactions are ultimately wound up. In other words, as soon as it goes into a deal, Blackstone's 20 percent carried interest - that great profit engine of private equity - will be valued like a salable financial instrument, and recorded as an asset.

Noncash profits today, in eager anticipation of an undated and uncertain but rosy future, and investors - including the Chinese government - lining up to hurl their funds at the prospects. Sound familiar? Has everyone forgotten Enron, the creative energy trader that crashed, or the academics' darling among the trading models that flamed out, Long-Term Capital Management?

Generations ago, the investment maxim on Wall Street was "buy on the rumor, sell on the news." The lore in the bubble years of the 1990s then became, "Buy on the fantasy." All too often, the result was "hold till the debacle."

The lesson seems irresistible: The origins of the next wave of corporate misadventures will be a new set of compelling stories. After all, we have been eager to devour simplistic myths and fables ever since our ancestors gathered around the fires in front of their caves, to listen to tales spun by those hailed, rightly or wrongly, as the wisest men in the tribe.

Here's an example: Because I dislike shopping, I look increasingly to catalogs. One features clothing and accessories no different in quality or cost from a number of others, but its goods are promoted in seductive little vignettes that locate the wares in such modestly exotic locations as Mumbai, Portofino or West Egg. That's good enough for me.

Consumers willingly buy into a good story. Brands of premium ice creams are all as alike as Tolstoy's happy families, but think of the success of Häagen-Dazs - a word concocted from no known human language, but evocative of Danish quality. And think of two unknown guys from Vermont, Messrs Cohen and Greenfield - mythicized as Ben and Jerry.

We buy look-alike vehicles, by reference to wilderness spots those vehicles will never visit - Denali, Sierra, Tahoe, Kodiak. Again, why? Imagine a marketer trying to sell a 4x4 branded for its real venues - a Chevrolet Strip Mall, a Subaru Speed Bump, or that new luxury offering, the Cadillac Cul-de-Sac.

Financial products and services are subject to the same power of myth. The meltdown this year in the subprime mortgage-backed securities market destroyed a bubble built from two stories: first, that ever-increasing housing prices would forestall a reckoning for credulous but unqualified home buyers, and second, that the inverse relationship between bond coupon and default risk had somehow been suspended for equally credulous investors.

Neither proved true, but the crash in this industry segment has failed to dampen the appetite of a myth-driven market. No less a tale-spinner than Warren Buffett has warned of unsustainable returns for alternative investments. But, depressingly, it appears that the only information commanding attention is that conveyed in stories worthy of re-telling around the modern version of the prehistoric campfire.

So today, the story of Blackstone's IPO overrides two antagonistic realities: that the private equity funds are awash in the cash of ever-smaller investors, even while chasing deals that are bigger and richer but doomed to deterioration in quality and results.

Blackstone's circular approach to its profit picture - booking profits today based on a collective blind vote of confidence on a future bet, as a proxy for real results down the road - not only echoes the immediate past of Enron and LTCM. The same approach came to grief in the late 1960s for the investors in Bernie Cornfeld's Swiss-based Fund of Funds, which did the same in a wild bet on deep oil in the Canadian Arctic.

But memories are short, and if the stories are timeless, so are the failures to learn from the past.