Re:Balance -- Jim Peterson

Previewing 2010 -- And a Note of Thanks

As the old year winds down to the winter solstice and all those rituals by which we mark the holiday season, a brief look ahead.

Depending on reckoning, the New Year will either end an old decade or begin the next one. Whichever, here are a few events that will feature in 2010 among the on-going challenges to the global structure of large-company assurance:

• The Supreme Court in the US may well declare the PCAOB to have been illegally constituted (here or here). If so, predictable spasms of re-enactment and ratification by the SEC cannot successfully encompass such issues as the viability of pending investigations, the legitimacy of past inspection reports, or the need to re-register all the foreign accounting firms.

In the context of those issues of contention, the legislative mischief to be wrought by a Congress offered a blank page on which to re-debate the Sarbanes/Oxley law can scarcely be imagined.

• The fits and starts of accounting standards convergence will have no more traction than a pig on roller skates. The announced retirement of Sir David Tweedie as head of the IASB (here) will take one prickly personality off-stage, but will not solve the antagonisms among competing country and industry level interests. And as the scope of complexity and judgments within both GAAP and IFRS figure to be as significant as those between reporting systems, the achievability of comparability and comprehension will remain as elusive as ever. 

• Attempts to impose liability on the large accounting firms’ international structures will continue apace. The success of BDO International in confining the Bankest verdict in Miami to the Seidman firm alone (here) means that if that $521 million exposure becomes enforceable, BDO may need to find a new US member firm – a tactic painful enough for that organization but which none of the Big Four could achieve under like conditions.

Flashpoints for structural threats will include the Madoff-related feeder funds litigations, concentrated in the US but also spread around the world, and PwC’s exposure on Satyam.  And with PwC’s Indian partners on Satyam about to observe their first full year of local imprisonment, that network's attempts to extract itself from class action exposure in the American court system (here) raise the interesting question whether submission to Indian justice is really a preferred strategy.

• Tempting as it might be to be lured into the speculation about identifying which of the Big Four firm is most likely to disintegrate under the combined pressures of litigation and government threat, in 2010 or otherwise (here), I will decline – since the determining factor is the unpredictable timing of the cases themselves. Specify the judges’ scheduled trial dates for the 25 biggest cases hanging in Damoclean fashion over the large firms – and only then would I be able to offer a view.

• More broadly, strategic decision makers in the world of financial information will continue to confront the volatility of government conduct – an under-recognized factor in their overall risk assessment methodologies.
  

The reactive nature of public officials has been marked in recent years by an ad hoc cascade of unpredictable and unintended consequences – ranging in scope and scale from the back-of-envelope bank bail-out schemes to the bonus supertax in the United Kingdom to the first-ever invention in Dubai of a default-driven debt reorganization scheme of uncertain application or reliability.

So life in the forthcoming year will not be boring. 

Meanwhile, in this space, Re:Balance observes its second birthday. Launched in January 2008, this venture was the evolution from “Balance Sheet,” the column I had the six-year privilege and good fortune to write for the International Herald Tribune.

The challenges have been fascinating, starting with the anxiety-inducing migration from old-style print. No less than the accounting firms, the IHT itself -- like the other newspapers -- pursues its fading struggle in search of a sustainable niche business model. While in the world of rapidly mutating media platforms, the near-term impact of the likes of Twitter, Facebook and Kindle will continue at a dizzying pace to re-define the information landscape.  

It has been most gratifying over these two years, both to participate in community with an expanding group of smart and incisive commentators, and to experience steady growth in readership and especially in subscribers.

For these opportunities, I thank you all for your interest, your insights and your inputs.

Merry Christmas -- best holiday wishes -- and a healthy, peaceful and prosperous New Year to all. 

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Invitation to a Conversation: If the Auditors Were Missing from the Financial Crisis -- Let's Ask Why

 

Last night I saw upon the stair

A little man who wasn’t there

He wasn’t there again today

Oh, how I wish he’d go away

 -- Hughes Mearns, 1899

 An under-appreciated power of the bloggers is the capacity for a two-way conversation, right out in full public view.

 That was my reaction, anyway, to Francine McKenna’s December 7 post, “They Weren’t There: Auditors and the Financial Crisis” – the gist of which is that the Big Four firms, who audited every one of the institutions complicit in the financial crisis, have been absent not only from visible influence on the catastrophe, but also from the post-mortem recriminations and accountability.

 Any regular reader here should also be subscribing to Re:The Auditors, where Francine airs a central theme:

“The auditors should have been there, as a last stop, where the buck should have stopped, as gatekeepers, watchdogs, advocates, and the last bastion of standards and expected values shareholders can look to.”

Here – in response to the always tart-tongued Francine -- is why the auditors weren’t there:

The simple if depressing reason is that their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism -- having lost any value it may once have had, except for legally-required compliance (here). 

If that single page disappeared from corporate annual reports, no honest user of financial information would admit to missing it. Nor, offered the choice, would any rational CFO pay the fees to obtain it.

There is plenty of assurance that users would value and pay for – that much is clear from the debates about the largely unrealized usefulness of reports on governance, sustainability and intangible assets outside the scope of historical cost-based reporting (for specifics, this column of mine goes back to April 2006).

But not in the current liability environment, where the large accounting firms are captive to their business model and paralyzed from innovation by their twinned lack of vision and influence.

On the other side, the regulators’ mantra that “audits are essential” is no more than the unexamined and self-reflexive assumption that audit reports will simply and always be there – like air or water or electricity. Whereas, if another fragile Big Four firm does trip into disintegration, nothing within the capacity of any regulator on earth will be able to put the shattered networks back together again, or compel the delivery of audits when there is nobody left to perform them.

If there is to be an adult conversation around this issue -- and along with Francine, there are real participants -- for general examples, Tom Selling's stimulating Accounting Onion, Dennis Howlett's acerbic AccMan, or Richard Murphy's Tax Research UK -- there are at least three other chapters to be aired, at whatever length is needed for credibility:

First, it is past time to put final closure to the talk of unachievable structural “solutions” to the Big Four’s complete dominance of large-company global audits. None of these can happen – as sketched out here – whether it be growth to competitive scale of a Five or Six, break-ups to restore a new but even further weakened Eight, mandatory rotation, new insurance or outside capital, liability limitations, or government take-over of the entire function.

Second, the financial structure of the private Big Four partnerships must be recognized as too weak and limited to sustain their current exposure -- here. Unlike the banks, their franchise is not “too big to fail” – the question is whether there is a better cliché than “too weak to survive.”

Finally, as a message to the Big Four leadership who have no choice but to get out in front, the private sector must acknowledge that no help will be forthcoming from government. Legislators – whose essential DNA bars them from any activity other than belated over-reaction – cannot be counted on for anything other than interference (here).

Worse, coordinated regulatory strategies are impossible at the global level – witness the floundering over GAAP / IFRS convergence as a simple example – while in the United States, a populist-oriented administration is not about to provide relief to a white-collar profession perceived to be overpaid and under-performing.

So there is no falling back upon the fallacious assumption that “’they’ won’t let another firm fail.” There is no “they” – no regulator or politician with the vision, interest or authority to prevent a debacle.

Francine’s massive army of readers is a potential force to be reckoned with – and has plenty at stake, whether as practitioners with careers-at-risk or users in search of better quality financial information. 

With their engagement, the evolution to a sustainable, achievable new model of reporting and assurance is possible – however unlikely, absent real commitment to a fresh and holistic approach.

But the dialog has to move beyond whiny finger-pointing, and the simplistic recitation of unrealistic “solutions.

And the sooner, the better.  

Thanks for joining this dialog. Your comments are welcome either here or to Francine. Please share with friends and colleagues. And if not a subscriber, you are invited to join at my Main page.

 

Measuring Corporate Stewardship by the Century -- A Lesson from the Oak Groves

"I know a bank where the wild thymes blow" --

    Oberon, Shakespeare's "Midsummer Night's Dream," II,i

A few words further (after these of November 10th and 17th), on corporate stewardship, and the ability to assess management's commitment to long-term sustainability.

The context is the measure of dysfunctionality in the dialog, with Lloyd Blankfein’s year-end bonus at Goldman Sachs expected to establish a compensation benchmark for the entire financial services sector.

Despite his vilification for both Goldman’s off-message diversion of $500 million to the aid of small businesses, and his own tone-deaf joke about “doing God’s work,” there is no other banking CEO being publicly fitted for a halo. And his company’s record is compelling, even though unless poor Blankfein suddenly develops the political savvy to foreswear all pay for this year, he is going to catch media hell no matter what take-home figure he tries to justify.

To take a long step back in history, consider the vision, commitment and behavior of the great canal-building companies of Victorian England.

These innovators not only joined with the newly-constructed railroads in making possible the Industrial Age, by achieving the first inland transport break-throughs in human history – re-writing the limits of bulk and speed that had been constrained by the capacity of an ox-cart and the pace of a horse and rider.

Knowing that the great oaken beams and timbers in the intricate gates of their lock systems would eventually require replacement, the canal developers had the foresight to plant groves of oak saplings around the huts of the lock-keepers – not for the shade and the aesthetics, but to assure a ready supply of mature trees when needed, many decades into the future.

That their legacy is now picturesque rather than practical owes only to the unforeseeable over-taking of technologies based on electricity, internal combustion, silicon and rocketry.

But sadly, it is no less unthinkable that their modern successors – the chief executives of the large airlines or trucking companies – or their counter-parts in banking, industry and professional services -- should invest and manage for their future based on such long-range planning.

Instead, there is a disconnection between managements’ incentives and long-term sustainability strategies -- as laid out by the guru of game theory, Bruce Buena de Mesquita, in his provocative and challenging new book, “The Predictioneer’s Game.” (For reviews, see the book's website. For the lite version, see his September 28 appearance on John Stewart’s Daily Show.)

His chilling example is the loss of vision of the Arthur Andersen leadership in the period leading up to the Enron debacle:

As he puts it -- under the grim caption, “Incentivizing Ignorance” (pages 116 et seq.) -- Andersen’s senior management “helped foster their own demise by not erecting a good monitoring system to protect their business from the misbehavior of their audit clients,” chiefly because ”Andersen’s most senior management genuinely did not seem to understand the risks they were taking.”

And why? Because as he puts it, “costly litigation … would not be settled until ten or so years after the initial prediction of risk.” But by that time “the engagement partner who brought in the business in his early to mid-fifties was retired and enjoying the benefits of his pension.”

Which creates the disconnection: by then, “the money for the defense was coming out of the pockets of future partners,” so “the financial incentive to know was weak indeed.” 

Recent years have shown the pervasively destructive influence of short-term incentives – from the exploding volumes of unsustainable subprime mortgages, to the proliferation of incomprehensibly risky financial instruments, to the current stripping of seasoned employees for the sake of expense reductions -- putting at risk the retention of expertise and capacity as the economic cycle turns.

It’s a sorry statement on leadership that Lloyd Blankfein is one of the few left standing, when so many short-visioned leaders have been shown unwilling to show the kind of commitment to maintenance and stewardship of the 19^th century canal builders.   

 

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