This column was originally published in the IHT on August 27, 2005. With other related work in the pipeline, I pick it up now mainly for archival reference, although -- with apologies for the anachronisms -- it remains just as current today as it was then.
Plot Twist Hits Reality
This has been a good summer for melodrama. First, there was Steven Spielberg's film "War of the Worlds," with its specter of alien invaders. Then there was "Attack of the Giant Liabilities," with the mega-settlements paid by banks in the Enron case - and the prospect of more to come in the cases of Parmalat, AIG and others.
The movie's hero was Tom Cruise. No similar savior exists for the Big Four accounting firms, beset by performance worries, liability overhang and structural threats to the viability of their core product, the standard audit.
But as part of a healthy debate over the future of the profession, a proposal was floated in July by a fellow columnist, Joseph Nocera of The New York Times -- here: Corporations would buy an optional "audit insurance," which their insurance companies would issue after a new and separate form of audit examination. This new coverage would, in theory, protect shareholders from losses resulting from faulty auditing.
An entertaining idea. But is it realistic? A few questions to explore:
Are there accounting firms available to do this new work?
The U.S. Securities and Exchange Commission and other regulators are not willingly going to surrender their requirements for standard audit reports, so companies would have to find a second accounting firm with the skills and resources to perform the new audit. That, by definition, means another member of the Big Four: PricewaterhouseCoopers, Ernst & Young, Deloitte & Touche and KPMG.
The problem is that most Big Four clients - after eliminating their current auditor and any firms of which they are consulting clients - will find there is at best only one other firm eligible to bid for new work. This was shown last autumn when Fannie Mae had nowhere to go but Deloitte after firing KPMG. The choice, already poor, threatens to become irreducible.
What about personnel?
The Big Four firms are already operating flat out, to the point of staff abuse, under the burden of work required by Section 404 of the Sarbanes-Oxley Law, and they are hiring workers as best they can to replace those they chew up. It is not a recipe for success to think that they could ramp up further, to perform a new, high-value service with workers hired from the next lower level of education and professional competence.
If the current audit firms took on a new role, what additional work would they do?
Auditors today already put their reputations and their survival on the line by issuing opinions that financial statements are free of material error. There simply is no more or different work they are competent to do - either to bolster that opinion, to manage their overhanging catastrophic litigation exposure, or to entice the insurance companies. Because if there were, they would be doing it.
Would the numbers work out?
As Nocera recognized, the problem is one of scale. Audit insurance would never cover an Enron-like debacle - namely, investor losses from a $67 billion bankruptcy. But in positing that the new coverage would be more than enough for shareholder losses from bad audit news, he misses two key points.
First, in the U.S. legal system the auditor can now be held liable for 100 percent of all investor losses, even in a large-scale debacle like Enron. Second, whether or not a shareholder suit ever comes to trial, the escalating size of the pretrial settlements - like those of the banks in Enron and WorldCom - threatens to eat up the accounting firms' total capital.
In other words, an incremental addition of small-scale insurance is a proposed solution for the wrong problem. It's the mega-cases, the ones threatening to kill the Big Four, that are running amok through the current legal system and its puny arsenal of defenses.
Would the insurers want to play?
The popular perception is that insurance capital is a rainbow pot of infinite size. The truth is that the role of insurance as a risk-spreading intermediary is constrained by competing demands on its limited capacity. The insurers, burned by a generation of bad experience, have already looked at the auditors' exposure and are devoting their resources to more predictably quantifiable disasters - like hurricanes and airplane crashes.
Audits of real value to investors can be done - but only with realistic and achievable standards, at higher cost, and with tolerable liability limits. The chances of getting there, with the engagement of all the necessary players, may be as unlikely as an invasion of aliens. The process has just begun.
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