Re:Balance -- Jim Peterson

Can Another Audit Firm Collapse? Absence of Evidence is not Evidence of Absence

Sitting out these balmy summer evenings, I have a clear look at my neighbor’s corroded and rusty front porch, which is diagnosed as a clear hazard, at risk of collapse at any moment.

He stubbornly refuses to replace the rotten ironwork, despite the dual exposures: the lawsuit when it falls, perhaps under his visiting grandchild or the postman, and the disclaimer of coverage by his insurance company based on his willful inaction.

“It’s stood there for thirty years,” he rationalizes. “So there’s no problem.”

Wrong. Just because it hasn’t happened doesn’t mean it can’t. Or won’t.

It’s so commonly mis-apprehended: absence of evidence is not evidence of absence.

The towers of the World Trade Center stood tall and firm – until the morning of 9/11/01. John F. Kennedy was a vital and glamorous president --until November 22, 1963. Bear Stearns was a maverick Wall Street success -- until the spring of 2007, when the failure of its models and its products made it the poster child for an industry floundering without control or direction.

The past is an unsatisfactory measure for the proof of a negative today.

Look at the Australian airline Qantas, with its a unique and admirable record – never a passenger fatality, over its entire history. Does that mean it can’t happen?

Qantas surely enjoys a favorable comparison with commuter carriers in rural China or the flag carriers of African despots. But the recent news photographs of the Qantas fuselage mangled by an exploded oxygen tank make this graphic point: any system designed and run by human beings is subject to a non-zero risk of large-scale breakdown and terrible consequences.

On these pages, not surprisingly, that comes around to the survivability of the current model for the delivery of audit services to the world’s large companies – the franchise dominated by the Big Four firms.

There is a sterile unwillingness in the public dialog to acknowledge and act on the real existence of a catastrophic threat. The committee convened by the US Secretary of the Treasury is due to issue its final report next month on the sustainability of the audit profession – here -- and there is every indication that this group of wise persons will not even reach a consensus statement on the credible existence of a threat to the firms’ survival.   

My neighbor’s mis-guided rationalization about the safety of his porch, that “it can’t happen here because it hasn’t so far,” is severely undercut by the porch collapse two doors down the street – another house of identical age, design, construction and weather exposure.

And what are those blithe about the threat to the audit firms learning from the speedy disintegration of the Arthur Andersen firm in 2002? Unthinkable as it would have seemed in advance, reality struck within a matter of weeks, despite Andersen’s 90-year history as a robust and stable enterprise, a leader of the profession, with both profitability and cohesion that were the envy of its peers.

How is it possible, either for my short-sighted neighbor or for those professing concern for the future availability of a sound and stable large-company assurance function, to avoid leading any discussion agenda with this reality: “Collapse can happen. And we had better call in the safety engineers before somebody really gets hurt.” 

But then, who is there to answer to call? Where the leadership on this vision might be found is a matter for discouragement, if not for despair.

The regulators? Not in the closing months of the Bush administration. Treasury Secretary Paulson has his pre-departure plate full with the credit markets and a rescue for Fannie Mae and Freddie Mac. When a typical bureaucrat’s idea of “long-term” strategy means avoiding an issue long enough to foist it onto a successor, no more can be expected of the Paulson Committee than the very low expectations threshold of a politically correct assembly of antagonists.

The financial statement users? If the recent letter to European Markets Commissioners Neelie Kroes and  Charlie McCreevy from the International Corporate Governance Network is any indication -- here -- the investor community is still fixated on such quaint if unworkable notions as small-firm competition and distaste for liability caps.  

And what about the leadership of the large firms? Here is the challenge to private sector leadership, where innovation in the free-market system should be expected to reside. It will take courage beyond that shown so far, for a Big Four chief executive to inform his partners that their business model is broken, and requires replacement for the sake of future survival.

If not, hindsight will charge the profession’s current leaders, whose state of public denial still avoids that difficult step, with a dereliction of their stewardship obligations to their younger generation. Because nobody else is going to rise to the occasion, the question is whether it matters enough today that they will. 

Wisdom on Catastrophic Risks -- Benoit Mandelbrot, "The Misbehavior of Markets"

A recurring theme at the American Accounting Association convention last week, on the challenged condition of the large audit firms and the risk of their collapse, is their version of the unforeseen tumult suffered since last year in the credit markets:

Namely -- just as trading markets seized up when valuation models broke down and expectations were blind-sided -- there is a fundamental disconnection between the moderate, inside-the-bell-curve nature of auditor assurance, carefully limited to “reasonable” and “fair” presentation, within “material” limits, and the severe and dramatic events that auditors do not foresee – typically large-scale corporate failure or fraud – that have the potential to trigger a firm’s catastrophic disintegration.

Nassim Nicholas Taleb’s 2007 best-seller, “The Black Swan”, which I reviewed here, provided the now-popular name for these unexpected but severely consequential events. Better, Taleb pays homage to Yale University mathematician Benoit Mandelbrot – whose 2005 book, “The (Mis)behavior of Markets: A Fractal View of Risk, Ruin and Reward', is highly recommended reading for anyone engaged in strategic decision-making under conditions of risky and incomplete information.

My review, below, was originally published in the International Herald Tribune on April 16, 2005:

Book Report: Why Markets Don't Perform

That Benoit Mandelbrot's latest book, "The (Mis)Behavior of Markets," should be squirreled away on the Accounting shelf of my local bookstore speaks volumes about the Yale University mathematician's reach - and his creativity.

.

Mandelbrot, 80, is probably best known for his groundbreaking work on fractal geometry: the cloud formations, wind tunnel patterns and rocky coastlines by which he has over several decades illustrated the underlying structural orders within nature's unpredictabilities. As popularized since his 1982 book, "The Fractal Geometry of Nature," and in James Gleick's 1987 best seller "Chaos: Making a New Science," fractal geometry describes complex, irregular phenomena. Seen as patterns whose shapes repeat up and down many orders of magnitude, from the distribution of galaxies in the universe to the shapes of cauliflower florets, fractals are modeled by turbulence and volatility, not by the smooth laws of certainty going back to 17th-century calculus.

.

In Mandelbrot's new book, written with Richard Hudson, a former editor and reporter for The Wall Street Journal, his skeptical message is aimed at the broad audience of investors and other participants in the world's securities markets. The same fractal approach that explains the limits on advance calculation of the path of a hurricane or the collapse of a species' population also teaches that markets are more risky, more vulnerable to violent disruptions and less well understood than conventional wisdom is prepared to understand or acknowledge.

.

To back up his assertion that the entire body of market learning, based on the concept of an efficient market, is elegant but fundamentally flawed, Mandelbrot observes that conventional theory greatly understates the likelihood of ruinous events. As evidence, he cites the "Black Monday" collapse of the Dow Jones industrial average on Oct. 19, 1987; the meltdown of the Long-Term Capital Management hedge fund in 1998; and, most ruinously, the calamitous upheavals of Sept. 11, 2001.

.

As Mandelbrot puts it, these events disprove the conventional bell curve of events spread over a smoothly continuous time distribution. They reveal the entire body of economic model-building - on which depend modern financial strategies ranging from index funds to the Black-Scholes formula for stock option pricing - to be as archaic as the tinkering of geocentric astronomers before Galileo came along.

.

Mandelbrot sees the need for a new body of fractal analysis that would illustrate that stock-price bubbles and market crashes are inevitable - so long as investors continue to behave as if they can search out patterns in the markets' patternless behavior.

.

In other words, there is great learning in the truism that as flawed and obsolete as the old methods are, they work well most of the time - except when they break down and don't work at all, which is exactly when great fortunes are made but mostly lost.

.

Mandelbrot himself has spent a lifetime surmounting the odds of extreme and unlikely events: He was a wartime refugee and fugitive in France, an academic survivor as a dropout from that country's top school, diverted from university life to the labs of IBM.

.

This perspective would explain why he engages in no small amount of ax-grinding over the hostility his views on the markets have elicited. His well-sharpened tools are on full and genial display. But by consigning all his mathematics to the book's endnotes, Mandelbrot asks most readers to take his positions about market behavior on a combination of faith, persuasion and good graphics.

.

As a self-proclaimed seeker of patterns in a universe governed by rules both simple and elegant, even if their consequences are turbulent and chaotic, he draws connections from the everyday vocabulary of common observations: The stock traders' colloquial description of a "stormy" day in the trading pits is echoed in the swirling turbulence of swings in commodity pricing. And he finds useful the observation that stock price charts follow similar shapes, whether scaled by the day, month, year or decade - just as with other patterns in fractal geometry.

.

Mandelbrot has not produced a how-to manual that can make readers rich. But he does assert that it can help them from getting poorer - unless readers suspect and act otherwise, in which case the symmetry of marketplace purchases and sales will lure some to take Mandelbrot as a guide to taking up risks that others would shun.

.

The careful would find inspiration, if not from the deeply skeptical Mandelbrot himself, in the advice of Shakespeare's Julius Caesar: that the tide in the affairs of man, if taken at the flood, leads on to fortune.

.

The Accounting Professors Ask: Are the Audit Firms Sustainable?

Spending a week in August at a convention of three thousand accounting professors would not be just everyone’s idea of a good time.

But as the 2008 meeting of the American Accounting Association winds down in Anaheim, California, the phrase “where fun goes to die” would be more than a little harsh.

To some, the mind-numbing acronymic jargon of IFRS and ERM and XBRL might yield to the near-by temptation of Disneyland or the division-leading Angels playing baseball just down the road. But the topic and speaker quality has been high, and the attendance both loyal and durable.

A high point for me was the opportunity to be part of a panel that took up the compelling question, “Is the Current Business Model of the Audit Firms Sustainable?”

The quality of the public dialog has left open to question the seriousness of the lip service being paid to the audit profession, and the ostensible importance of large-firm assurance to the world’s capital markets. Tom Selling has been sharp-edged and perceptive in The Accounting Onion – here – in his criticism of the SEC’s Committee on Improvements to Financial Reporting. I’ve raised my own issues over the flaccid performance of the US Treasury’s Advisory Committee on the Audit Profession -- some both here and here.

Credit for convening the AAA panel goes to Gary Previts, historian and professor of accounting at Case Western University and, probably not coincidentally, a member of the Treasury Committee. Wearing a third hat as president of the AAA, Previts reasoned correctly that the accounting academics have their own “skin in the game” on the sustainability issue.

That’s for at least two reasons: First, the universities are called upon to provide the intellectual horsepower, research platforms and ivory-tower resources that support the profession’s capacity and relevance in a complex global society. Second, it’s these professors’ students who are the very feedstock into the gaping pipeline of personnel needs of the large and small firms, industry and government.   

Despite being assigned the death slot on the meeting’s 150-page schedule -- after lunch on the last day of the program -- turn-out for the session was robust and energized.

On the table were the academics’ reasons why the current reporting and assurance structure requires evolution – ranging from the impact of information handling technology on the firms’ partner:staff leverage, to doubts about audit methods to verify intangible assets, to skepticism that audit risk models can deliver quality results because they are ill-suited to assess either management’s major areas of judgment or the deliberate acts of fraud or manipulation.

Bolstering these professorial perceptions were the observations from “the street” – the hazards and risks that must be part of any serious sustainability discussion:

•    Litigation with claims exceeding $100 billion loom over the large firms, with the immediate potential to overwhelm the modest level of their partners’ capital.

•    There are no achievable survival strategies, either singly or in combination – whether liability caps, insurance, new competition, ownership changes or outside capital.

•    The players in the public discussion, all acting in presumed good faith but with antagonisms and limitations of vision, include the firms themselves, with the weakness of their focus on improvements when their performance remains subject to criticism, and the issuers and the regulators with their own interests being served by the preservation of the status quo.

•    The next large-firm collapse will take the system down, not from four firms to three, but all the way to zero, for reasons of overwhelming concentration, inability to absorb the work demand, and predictable risk avoidance in a dysfunctional system.

•    Finally, the reporting and assurance model coming down from the 19th century is obsolete and unsatisfactory in a modern context -- but cannot evolve, under the existing legal and regulatory constraints, into new forms of assurance that the capital markets would value and be prepared to pay for.

What the AAA session could only touch on – and what remains as the next step – is a serious and comprehensive effort to do the “blank page” design work for an assurance model responsive to the needs of the 21st century.

That delivery model will evolve, for certain, because change cannot be stopped. The only question is whether it will occur before or after the collapse of the current system, with the attendant market cost and disruption and the dispersion of the large firms’ personnel, reputation and financial and intellectual resources.

So here’s a message from academia, to the regulators, politicians, think-tank leaders and the large firm managements alike – all sitting there, heads down in denial, confusion or resistance:

There is a lot of hard but rewarding work that has to be done to avert a catastrophe. Is anybody listening?