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• That the traditional form of auditor’s report is obsolete and provides no investor value, especially compared to the possible forms of assurance that are impossible under the current model -- here;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.
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.
Have you given any thought of having an audit review rather then a full audit.Many non profit and charities use them as they cost from $400 to $2,000.Half the cost of a full blown audit.
Posted by: Chinnu | August 24, 2012 at 12:41 AM
Consider this "cost" of attempted cost-saving: as revealed in the spring of 2012, the town of Dixon Illinois -- which engaged a large regional firm to do annual compilations, and a one-person practice to do audits -- suffered $ 53 million in defalcations by its chief financial officer.
The responsibilities and exposures of the gate-keepers are, at this writing, still unsettled.
Jim
Posted by: Jim | August 26, 2012 at 12:26 PM