If the Banks are Nationalized -- Why not the Auditors?

I’ve been in a lively exchange with Francine McKenna (Re: The Auditors) – she of the stiletto heels and equally sharp tongue – especially about her tart message last week to Senate banking committee chairman Christopher Dodd (D-Conn.):

“Demand PwC be fired as AIG’s auditors, and get rid of Fannie Mae and Freddie Mac auditors (Deloitte and PWC, respectively). Have the PCAOB audit them directly.”

Take Francine’s position (elaborated here) for discussion, without necessarily agreeing, that the Big Four should be stripped of their engagements for the large financial institutions subject to government rescue or take-over. At the heart of the concern: with all the Big Four carrying death-penalty litigation into the current mess, and all being targets of new mega-claims, there are no available private alternatives.

Her interesting view is that with Fannie and Freddie taken over – and with the government’s controlling interest in AIG and about to invest in nine of the country’s largest banks -- its interests and those of taxpayers are best looked after by a government-run audit function as well.

Expand the PCAOB’s current remit, she says, or create a new form of inspector general.

Despite a skeptical first reaction, this may be the plausible path to the re-engineering of the model of private assurance -- which I’ve been arguing (for example, here) is inevitable with a litigation-driven collapse of the Big Four themselves.

Here’s why:

First, Francine sees no problem in building a federal audit agency. Currently the PCAOB has 500 staff. To build a remotely credible capability, it would have to grow by orders of magnitude, at all experience levels and in world-wide locations. But personnel will be available: The wave of bank failures, bail-outs and mergers is drastically reducing the population of surviving institutions, so the net loss of clients among the Big Four is about to put small armies of bean-counters on the streets.

While it is depressing to think of the creation of yet another vast bureaucracy, the civil service manpower needed through the years of the trillion-dollar bailout reduces opposition to a quibble. It does require noting, however, that the hiring will be of those unable to migrate their stature and compensation in the private sector – namely, the superannuated and the second-rate – not exactly a recipe for staying ahead of a sector of mind-bending complexity.

It bears asking, also, how the concepts of independence and avoidance of conflicts could be squared with the appearance of one agency auditing another. But since the intellectually sound argument for “independence in fact” gave way decades ago with the rationalized acceptability of “client pays,” it would be an easy step to condone a cross-Washington audit function.

As for the questionable value in the market place of an report both by and for the government, the current one-page “pass-fail” audit report is already a no-value anachronism (see here), useful only for statutory compliance but of no useful purpose to investors. So it could as well be done by a collection of civil servants, with the diminished level of attention and respect it would deserve.

Government assumption of audit responsibility opens this tempting door:

Even under state ownership, the huge and complex financial institutions will have undiminished future needs for sophisticated and specialized assurance – in such areas as financial product design and evaluation, process execution and operational soundness – which the Big Four should be both able and enthusiastic to design and deliver.

Freed from delivery of low-value but litigation-laden audits, they should in reason be evolving their services -- only under contractual terms unburdened by the threat of investor claims.

To be sure, for the sake of transparency and accountability of public funds, the banks themselves might well choose to offer to the outside world the reports they would obtain from the Big Four (or the niche providers who would no doubt arise by spin-off or new growth) – but this would be under strict limitations of warranty and liability. 

Tasting both the potential stream of new revenue and the liability relief offered under such a model could be heady for the Big Four, who might well see the potential to extend the model across the entire spectrum of public companies.

In practice, they could tender to a new audit agency the keys to their now-outmoded franchise – thereby finally unshackling themselves from its unsustainable burden. By evolving into sources of real user value, they would escape the looming fate of catastrophic collapse.

Senator Dodd has not given Francine the courtesy of a response – which seems a little ungracious, for a politician savvy enough about the new media to run his own blog and subscribe to an instant message platform.

Especially when she has lit the fuse on an issue ripe for political leadership. By taking up this opportunity, under Dodd’s sponsorship, the large firms could be enabled to survive --- to re-design their assurance products, to re-discover relationships with their clients, and to restore their purpose. 

Thanks to readers for joining this dialog; your comments are welcome, and if not a subscriber you are invited to sign on at the Home page – easy, free and non-commercial.

Comments

[Francine McKenna]

Jim, This is a great exposition of what started as two friends crying in their tempranillo over the state of the world. Would anyone believe we lament the loss of the Big 4 franchise as it's known? I think not, but it's true, since it should have been done well. But, unfortunately, the business model is riper than a chunk of ardrahan.
http://www.artisanalcheese.com/prodinfo.asp?number=10029

I take but only one exception to your post - the idea that the professionals available to the federal audit service would only be "of those unable to migrate their stature and compensation in the private sector – namely, the superannuated and the second-rate." Unfortunately, the firms are laying off professionals at all levels given their bankrupt recruiting, scheduling, revenue forecasting and redeployment capabilities. I think there will be plenty of well qualified and highly motivated professionals, especially up and until the partner level, who've had it with the current double-talk of the Big 4 and are eager to join in the public service spirit that President Barack Obama will bring to Washington DC in the near future...http://www.retheauditors.com/2008/09/deloitte-worst-may-be-yet-to-come.html

[Jim Peterson]

Francine --

Thanks for your uptake. I don't disagree that there will be first-rate talent on the market as a result of the large firms' adjustment to the nationalization of the financial institutions.

Even accepting the prospect of an outbreak of idealism under a changed administration in Washington, however, re-invention of the presently debased state of statutory audit under government aegis is, to borrow a phrase, "putting lipstick on a pig." Real innovation and creativity will be better deployed to new forms of assurance deployed and testable for value in the marketplace.

[Jason]

I liked the idea when I first read the post, but then I began to think about what that would look like in real life... and I began to get a little scared.

As a big four auditor myself, one that is currently looking at the prospect of a government job, I can say with certainty that you would get the "superannuated and the second-rate" which would make the audits almost as useless as they are now. Sure, the big four doesn't pay as well as the private sector (and is probably fairly close to government pay) but at least while working for the big 4 I know that I work with some very intelligent people who enjoy what they are doing and strive to be even better. Those intelligent people, who are always tempted to "jump ship" to industry for better hours and even better pay, would indeed jump ship in a heartbeat if forced to work for the government. If audit opinions are useless now, I would hate to see what they would look like under a government bureaucracy.

I also fear that GAO reports (done by "government auditors", which sometimes are very well prepared and insightful, go largely unnoticed and have almost no teeth to them. I'm afraid the auditor reports would be taken with similar heed and that private audit reports might then be requested again... re-instating audit firms with the added baggage of another government agency.

[Jim Peterson]

Jason --

Thanks for this, which is consistent with my hypothesis about a possible future. The answer to your concern about the lack of value of government audit reports is, I think, that if the large firms were freed of the business model that now locks them into doing that work, the smartest people would stay with a re-designed private assurance function that would provide newer forms of high-value services that both clients and users would value and pay for -- a model that would be exclude catastrophic litigation exposure and would therefore be sustainable.

Jim

[Ian Welsh]

Speaking as a non-accountant, the issue is that someone needs to do audits. Since the Big 4 have repeatedly shown that they can't be trusted to do the job properly, for various reasons including conflict of interest and because it's a low cost niche, something has to be done to provide reliable accurate audits.

Without doing so, there are going to be significant problems going forward that will translate into decreased company values, increased transaction costs and unwillingness to even do business is some cases.

Simply put, the system failed over the last 7 years, as it failed in the dot-com boom. The "best and brightest", proved that being bestest and brightest didn't mean a thing, since the incentives in the system and the structure of auditing were set up to make actually measuring risk something it was unwise to do.

I spent some time with a friend of mine who has math at the advanced nuclear physics level, who also has the necessary risk math to evaluate the risk models used in financial hedging. What he told me was chilling, the math was done improperly - events that would cluster together, that were not independent of each other, were treated as if they were. The result is that most credit default swaps, CDOs and so on, do not have the mathematical characteristics they were advertised as having.

The 'best and brightest' did not catch this, or if they did, they did nothing about it. Admittedly, that sort of math is really actuarial math, but if accountants don't understand it, they can't properly audit modern corporations.

So, dead seriously, I want to know how we fix that. And if the accounting profession can't come up with a way, then the cost will be very real and very large.

[Jim Peterson]

Ian --

Thanks for your comment, which those both within the profession and able to influence its future should take as an outsider's heartfelt plea for "something better" -- and consistent with my own view that since trade was invented, society has had need for first-class assistance with both accounting and assurance -- which emphatically does not mean that the structure necessarily will be that which has been all too familiar for decades. What will evolve, however, and the extent of disruption to get there, both remain very much uncertain.

[Diane Ursenbach]

Here I thought I was all alone. I couldn't agree more with
Francine.

You have to admit it takes some measure of audacity for the auditors to stand by and allow Fannie Mae and Freddie Mac to sink into the abyss of grand economic failure, take NO responsibility for any of it, and then have their hand out for more fees as they are allowed to continue auditing the two mortgage giants as if they had nothing to do with their untimely demise?? Excuse me, but this is an exhibition of colossal gall. That is like a man shooting his parents and then pleading mercy on the court because he is an orphan. These two firms are truly poster children for 'chutzpah'.

More infuriating about the dramas that have unfolded in the past few weeks is that it has all happened POST SOX. Any way you slice it, there remain two common denominators: Management still does not grasp the meaning of the term 'tone at the top', and the auditors still think that management is their client.

Doesn't anybody care about how the actions of management are going to affect the investor?

Here is a perfect example that hits close to home: my friend is a widow in her early 70's who invested every single extra dime she had in AIG since the 1960's. Until a couple of weeks ago, she was sitting pretty with almost $750,000 in various investment vehicles, paid up insurance policies, etc. Now she has $100,000- the SIPC limit for recovery. She cried for a week. Then she was scared. Now she's angry. My friend is an example of the investor who relies on the professionals and their expertise to do their job so she can have peace of mind. She doesn't care nearly as much about how management does their job as she does about how we do ours.

That is a snapshot of what it looks like at the bottom of the totem pole when we don't do our job right.

These debacles keep happening because (a) independence isn't independence if you're getting paid $25 million dollars a year for your services and (b) we have forgotten the purpose behind what we do: we are supposed to be protecting the investors and lenders who rely on us to give them an objective opinion on the state of the financial affairs of the companies they invest in and lend to.

At the end of the day, the real client - the true beneficiary of our services are the people who put up their hard earned money (or the hard earned money of others) into these companies so they can create jobs and products and services. This notion is what made certified public accounting a profession. Now, it is nothing short of a commodity.

At some point really soon, a collective effort needs to be launched with our Congressional leaders and point out ever so delicately that the Emperor has no clothes on.

The system the accounting firms work under with respect to public companies has not worked in the past, does not work now, and won't work in the future. We cannot wish public accounting into being something it isn't.

Until the paradigm shifts and change takes place, as history has just demonstrated, we are doomed to continue to repeat the same behavior with similar results, just different folks losing their money.

Drastic times call for drastic measures. I'm there.