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.

 

Comments

[wdf]

Solid summary ... the odd thing that struck me in reading this is how closely the Big 4 might be to the Big 3 automakers in many respects.

[Jim]

WDF -
Thanks. There's this big difference: you could take out any or even all of the Big 3 automakers, and there would still be a global over-supply of auto manufacturing capacity. Take out any of the Big Four, and the whole system of assurance crashes for want of viable alternative sources of supply.
Jim

[Charles H. Green]

Jim,

This strikes me as a clear, sober call to arms about the accounting industry.

I'm still not clear just what arms, and with what end, but your thinking clearly elucidates what the right story-lines aren't; and the first step is admitting we've got a problem.

Thanks.

[DavidE]

I guess you are saying that the Big 4 are useless and are beneficiaries of government rules requiring audits.

I think that each auditor should come up with their own assurance that they would give. The firms that disclaim responsibility would lose customers to those who do not disclaim responsibility.

Let the marketplace work!!!

[JD]

Jim

The auditors were there and just got it wrong. They will feel the pain from this trying to defend the lawsuits. Whether they can be successfully sued is another matter.

If one or more big firms fail as a result then so be it. In the long run there are enough other audit firms who will eventually step up.

JD

[Jim Peterson]

JD -- OK, except right down to your ending point. Under the present model of large-firm litigation exposure, independence constraints, limited capital and concentration of resources and expertise, it is just not the case that alternative providers would emerge to replace a failed Big Four firm. That discussion can be expanded at greater length, and has been, but it is over.

Jim

[Geoff]

I really think a big part of the problem relates to 2 things:
1. the very narrow confines of Audit Opinions. I think they should be more like bond ratings; insane to think all audits in the public sphere are AAA.

And 2. Audits who nag so incessantly about small stuff, it blunts the impactfulness when they show up with the big stuff.

One man's opinion.

[JD]

Jim

I appreciate that there has been much consideration and speculation about what will happen if and when one of the big 4 fails, including many arguments about why smaller firms will not be able to step-up. However, in the likely case that governments do not intervene strongly then the market is going to be the main determinant of what happens. The supply and demand for audits goes way beyond the big 4 arena and there are a lot of myths that permeate the argument that the next tier firms cannot step up. I don't believe that debate can possibly be finished whilst there is so much uncertainty about how the market would behave.

[Jim Peterson]

JD -- Thanks. Maybe. But there's no sign from either "the market" or the smaller firms of an appetite or the capability to "step up," and the entire record goes the other way. From here, sadly, the worst-case but also most likely scenario is that of a failure in which case the entire assurance structure will be tested under the most distressed conditions.
Jim