The Weekend Press: "Billion-dollar Lawsuit Could Destroy Top Accountancy Firms"

The Finance section of this Sunday's edition of the London Telegraph carried a piece by Sean Farrell, under the evocative and self-explanatory headline, "Billion-Dollar Lawsuit Could Destroy Top Accountancy Firms."

It can happen. Attention should be paid.

Farrell captures the essence of the structural weakness of the current model for the delivery of audit services to the world's large global companies, as demonstrated by the speed with which the Andersen firm disintegrated in 2002 under the stress of the Enron debacle:

"Andersen's collapse highlighted the fragility of a global accountancy partnership. As soon as the extent of the fraud was made public, Andersen's international divisions and partners not involved in the scandal detached themselves from the firm, making it impossible for Andersen to survive. The nightmare scenario for the big four – PwC, KPMG, Deloitte and Ernst & Young – is to be caught out by the next Enron." 

I talked at length with Farrell last week, while his story was in preparation -- and was gratified to see his uptake on the under-appreciated research done on the limited financial capacity of the Big Four to resist or withstand large-scale litigation claims, because as private partnerships they lack access to the outside investor capital available to public-company corporate structures:

"A London Economics study for the European Commission three years ago calculated that the biggest claim a London arm of a big firm could bear after the exhaustion of insurance was €540m (£474m). The report says: 'As firms have practically no assets of their own which could be mobilised, the partners of the firm would in such a case bear the cost of the adjustment. At issue is the size of the financial burden that partners would be willing to bear before the firm collapses'."

I've written on this subject before. See here and here for calculations of the "tipping point" numbers on the Big Four's exposure to litigation in the US -- where the largest threats are lurking -- numbers that should be eye-opening because they are miniscule compared to the firms' exposures. 

Farrell quotes me:

"(A)ccountants already face pressures from incoherent international accounting standards, huge potential litigation liabilities and their own failure to meet the standards expected of them. He says on top of these recurring problems firms now face mounting litigation connected with Madoff.

"Peterson says: 'What is not generally appreciated is that most accounting firms work with a level of capitalisation supplied by their partners that is woefully thin... There is no big four firm that could survive a judgment as high as $2bn'.

"He argues the fall of one more big four firm could cause the system to collapse because rules on conflicts and the big four's patchy geographic strength would prevent the remaining firms from mopping up the business as happened after Andersen's blow-up."

Critics of the accounting profession will have their say, as they well should. But no discussion agenda on the future of the large-company audit franchise is either complete or credible unless it includes the unsustainable nature of the current regulatory and legal structure, within which the business model of the Big Four firms is at mortal risk.

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Comments

[wYOA]

"As soon as the extent of the fraud was made public, Andersen's international divisions and partners not involved in the scandal detached themselves from the firm, making it impossible for Andersen to survive." NOT TRUE!!!! IT WAS THE INDICTMENT THAT CAUSED THE NON-US ANDERSEN FIRMS TO LEAVE. EVERYONE KNEW THE SIZE OF DAMAGES FACE IN THE ENRON CASE FOR 2-3 MONTHS BEFORE THE INDICTMENT.

[Jim]

It's Farrell's timeline, not mine -- and depends on how you define "as soon as." Because Enron was mooted by the plaintiffs' bar to be the first billion-dollar payment by an auditor, and a settlement in the $800 million range was reported as agreed in principle but scuttled by the firm's disintegration. Sums of that magnitude in context of Andersen's other pending litigation exposures would have inflicted a mortal wound on the firm -- the indictment notwithstanding.

[Small Business Bookkeeping]

I hope the issue would be settled immediately since it involves the big company's reputation.