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."