I was chided last week by a senior partner at one of the large accounting firms, who felt my views to be unhelpful to the strategy of liability reform.
The sensitivity was unsurprising, because the firm involved is among the most exposed to a litigation-driven catastrophic failure.
But with all the large firms holding hands together on the cliff edge, broad skepticism is entirely warranted. As they present their collective litigation exposure, it looks like a game of Russian roulette – only all the chambers are loaded, and the single variable is the bullet’s victim when the hammer next falls.
With the yawning chasm between their exposures and their resources, nothing is on the table by way of liability caps – whether in money or percentage terms – that is either (a) within the firms’ political reach, or (b) sufficient to enable their survival.
Just because they pursue a flawed strategy does not, however, make me the counsel of pessimism. The large firms have tools readily available for use – hence this update of a column first appearing in the International Herald Tribune:
Most of us experienced at least some childhood fear of the schoolyard bully. Fewer remember the adrenaline high of standing up, and the energy rush when the brave act of delivering a punch on the nose reordered the rules of the playground.
I was recently sympathizing with a just-retired senior partner of a Big Four firm. He was decrying the profession's miserable record against its critics - particularly over the bogus issue of whether auditors should perform non-audit services for audit clients. The debate was never fair, we agreed, because it was swamped by the flood of criticism that auditors could never exercise independent critical judgment when the corporate management under scrutiny was also paying the bills.
Because the critics ended up in control, the large firms sold or divorced from most of their consulting practices, failing to develop into the cross-disciplinary consulting and legal powerhouses they might have become.
According to my unhappy colleague, the auditors' problem was one of weapons. They had only the "nuclear option" - namely, complete withdrawal from the franchise of privately provided audits - which, at least to date, nobody believes they would ever use. So the firms were bullied into submission by aggressive regulators armed with nothing more than an ax to grind.
This is a thoughtful guy - smart enough to have extracted himself and his capital from his old firm before sky-high liability claims could gobble both of them up. But I think he is mistaken. The large firms have always had an arsenal of effective tactical weapons at their disposal. Here are a few:
• In financial statements for international use, there could be explicit recognition of the significant cross-border differences in both accounting and auditing standards. The goal of converged, high-quality audit performance is desirable, and approaching, but far from accomplished. There are substandard country practices, which candor should disclose. Users were ill-served in the last decade when the accountants' effort to introduce an "explanation of cross-border differences" in the Asian markets was bluffed off the table by hostile regulators in Japan and Thailand.
• The auditors could refuse to perform the lucrative but unmanageably risky reports on internal corporate controls required under Section 404 of the Sarbanes-Oxley law. As the engineering profession has known forever, any system designed for human operation has a non-zero likelihood of significant failure. So as a percentage of public companies have revealed horrific control breakdowns, the liability cost of Section 404 is yet to be reckoned.
• Financial reporting could explicitly recognize the uncertainty of management estimates and expectations. The auditor's report could catalogue the areas that rely -- fallibly -- on the models, plans, probity and credibility of management: examples include the future performance of exotic financial instruments or loan portfolios, the recoverability of research expenses out of new-product success, or the achievement of post-merger cost reductions.
• The auditor's report could draw an explicit line of materiality beneath which there is neither examination, evaluation nor auditor comfort. Although the audit sampling process cannot realistically go below some quantified level, whether in absolute or percentage terms, investors today are left in the dark as to what that is.
Regulator opposition to any of these would be expected - and rule changes would be required. But while the regulators have their place in professional oversight, it is past time for the firms to reclaim some turf. It makes no more sense that setting standards for the technically demanding processes of audit and financial reporting should be dominated by the political agendas of amateurs - however intelligent or well-meaning - than it would for the performance of cardiac surgeons or airline pilots.
It is the large firms, after all, who actually execute the large and risky audits. It is for them to force change in today’s hostile regulatory environment, and their failure to control the dialogue leaves them on the wrong end of the ongoing antagonism.
Unfortunately, the large firms have consumed their energy in the Sisyphean failure to attain liability limitations. Relieved of that limited strategic vision, they would see such timorous proposals as in the US Treasury Committee’s draft report – here – as popguns and peashooters against real tanks and artillery.
But like the chronic victims of the schoolyard, the large firms need the courage to stand up. Their franchise to provide large-company assurance is ever nearer to collapse -- so even if there is a little blood on the ground and some whining from the bullies, that is the requirement for their survival.
These issues are important, and the dialogue is not well engaged. I encourage you to send your comments – and to share this address with your friends and colleagues – and if not a subscriber, to sign up at the Home page, where it is easy, free and non-commercial.
Comments