Re:Balance -- Jim Peterson

The House of Lords -- Experienced with "Disconcerting Complacency" -- Looks at the Market Concentration and Role of the Auditors

Adulatory commentators are treating the March 30 report of the House of Lords Economic Affairs Committee on the market concentration of the Big Four audit firms and their role in the financial crisis (here) as a call to arms not heard since King Henry’s exhortation to his troops on St. Crispian’s Eve.

While the print media played it pretty much with a straight bat (here the Financial Times, the Guardian, the WSJ and the NYT), the blogging community went into adjectives-on-steroids: “hard-hitting” (both Ian Fraser and AccountingWeb), a “watershed” (Accountancy Age), “tough, no-nonsense” (BigFourBlog) and “skewers the auditors” (Francine McKenna).  

Yet soft a while. This on-high manifestation of the Lords’ work is hardly “band of brothers” material.

Truth told, other than its sound-bite charge that the auditors of the UK banks were “disconcertingly complacent” in carrying out their mission, the report is pitiably thin in substance:

Its most solid recommendation, first, is for mandatory five-year auditor rotation – an approach backed by nothing but hope for beneficial effects, and conspicuous by its adverse unintended consequences in Italy, the only major country with experience.

Second, the suggestion of “living wills,” for the relief of an audit firm in crisis, would follow the distinctly inappropriate model for rehabilitating a failing bank – which is an entirely different proposition. Bank separation of the good from the toxic involves a balance sheet of identifiable if hard-to-value assets and liabilities, to be worked through by a fungible and entirely replaceable leadership team – whereas the only value in a service-based accountancy partnership resides in its reputation and the highly-mobile skills of its people – both of which (as was shown in the Andersen disintegration) can dissipate faster than any putative rescuer can possibly control.

Third, the extent of Big Four concentration at the upper end of the audit market long pre-dates Andersen’s collapse in 2002. So the Lords’ buck-passing to the Office of Fair Trade, to re-visit yet again the age-old and insoluble matter of large-firm concentration, is hardly inspired or inspirational – especially in the complete absence of any indication of authority or vision as to how a split of resources and expertise could increase auditor choice or quality of performance.

Specifically: to split the large firms along industry lines would not increase choice. A Big Four firm depleted of its global-scale expertise in a complex sector – say, insurance or communications or defense contracting -- would have no more motivation or access to resources for a re-start than the current mid-sized firms – whose lack of appetite for the risks and challenges is already manifest.

Yet the alternative -- surgical bifurcation of existing teams of talent -- would devolve onto new firms, now smaller and weaker, all the existential challenges looming today over the Big Four themselves, along with the added burden of cost and management diversion to build duplicate centers of technical, industry, quality and risk management competence.

So on the actual content of the Lords report, it is either laughable or pathetic to invoke the image of Hercules confronting the stables of King Augeas. Instead of donning its boots and seizing a pitchfork, the Lords report holds a hanky to its delicate nose as it minces past the shit-pile, all the while whining that someone else, evidently the OFT, ought to get on with the stable boy’s dirty work.

Shame on the House of Lords committee, for a lazy approach to important issues of real substance. More shame on the observers failing to hold them to account.  


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Recidivism and Risk Management: Barry Minkow Goes Back to the Slammer

Son, always remember: some day, somewhere, a guy is going to come to you and show you a nice brand-new deck of cards, and this guy is going to offer to bet you that the jack of spades will jump out of this deck and squirt cider in your ears. But son, do not bet him, for as sure as you do, you are going to get an ear full of cider.

-- Damon Runyon, “The Idyll of Miss Sarah Brown” (1933)

 A question for those charged with risk management and fraud prevention:

 What’s your company policy on employing or doing business with ostensibly reformed white-collar criminals?

 And is a re-think indicated by the news that Barry Minkow, wunderkind among securities swindlers for the scam at ZZZZ Best in the 1980’s, for which he served seven years of a double-digit sentence on 57 counts, is negotiating a securities-fraud plea bargain under which he now faces fives fresh years of jail time (here).

My concern is a prosaic one – not Hollywood’s question whether his return to federal housing means that the pending Minkow bio-pic requires re-shooting of a new ending (here), or whether the February burglary of $50,000 at the Community Bible Church where he recently resigned as pastor (here) bears any of his felonious fingerprints (here).

It’s only this: Given the rate of relapse among those described by English essayist Charles Lamb as “so crooked that if they’d swallow a spike, they’d void out a corkscrew,” should a company concerned for its reputation and fiscal soundness ever yield to sentiment and invite such a fox back into its henhouse?

Experience over the years counsels against it. Examples in my own catalog include the large-company CEO convict, who finagled a reduced sentence via a convenient medical excuse, and was no sooner paroled to a halfway house than he took over its single pay-phone to peddle the rosy promises of new oil deals. Or the youthful CFO applicant who persuaded an employer of his time-served maturation, following bucket-shop charges; the naïve advice of the audit firm partner was to “keep the kid away from the cash” – unavailing to prevent a scandalous and catastrophic collapse and a portfolio of lengthy prison sentences for the entire executive team.

And it was surely foreseeable, following O.J.Simpson’s circus-trial acquittal, that his temporarily dampened symptoms of renewed personal violence would re-erupt – the only question being the period of his volcanic latency.

For a risk manager the decision-making process is a two-by-two matrix – evaluating the rewards and benefits of a yes/no choice whether to chance re-attachment to someone’s checkered past.

A successful result could yield good and honest performance – non-trivial, but likely not different from that available with many other candidates – whereas the negative – a relapse into criminality – would at minimum be seriously costly and disruptive.

On the other hand the cautious choice to forego the relationship would mean sacrificing the potential contribution of an ex-felon – again, a modest upside – although avoiding the destruction that a recidivist’s presence might cause.

The analytic process has its formulation in the 17^th-century French mathematician and philosopher Blaise Pascal’s wager on the existence of God:

Betting against the proposition, with no particular reward for being right, could – if proved wrong -- suffer the punishment of an eternally vengeful deity. Rather, the wager in favor of His existence carries no hazard if incorrect, but offers the upside of an eternity of bliss.

Minkow’s own now-former church is no doubt a repository of repentance, atonement, forgiveness and charity. Admirable qualities, all. But they should not overwhelm what is learnable from logic and experience.

Namely: the percentage of white-collar wrongdoers in the executive suites is small to begin with. But once the “contingent possibility” is established – that is, an already existing proclivity to misbehave – the risk calculus is fundamentally changed.

There is a cottage industry of ex-cons and their acolytes, working the book-and-lecture circuit and flogging scripts of penitence and redemption pitched to the credulous.

It is one thing to read their stories and even to consider the quondam relevance of their experiences. But the case is not made that they should be entrusted with access to the balance sheets of any enterprise involving other people’s money.

 

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Two Obsolete Models: Global Financial Reporting and Audit -- And Pimping Spam Viagra With AOL's Rogue E-Mail

 

Last week came a very peculiar e-mail, from an old and trusted friend whose judgments I have long valued and whose recommendations are informed by insight and experience.

There was no text – just a link. It led to the web site of an enterprise in Canada, offering remarkable discounts on an extensive array of exotic pharmaceuticals – mainly those promising cut-rate prices for exceptional enhancement in male potency and performance.

The note had multiple addressees, so it was evidently not a well-intentioned if gratuitous extension of concern for my personal functionality, satisfaction and well-being.

To pursue my second thought, I wrote my friend to ask if the site was being flogged as an outburst of his own endorsement and enthusiasm. His reply identified the third and real possibility – his long-standing AOL e-mail account had been high-jacked, and under hostile influence was engaged in stealth marketing beyond his control.

I have deliberately kept my distance from AOL for some years – first because a company capable of so thoroughly bungling its tie-up with Time Warner must suffer a fatal infection in its vision and its maladroit execution. But right at home, AOL’s long history of service lapses had finally ended with its sudden and irretrievable termination of my whole family’s portfolio of accounts, without so much as a word of explanation or a hint of assistance or apology.

So I have had a definite lack of interest in the recent kerfuffle over AOL’s bleeding of its declining but remarkably durable dial-up customer base to fund its $ 315 million acquisition of Huffington Post – a project of great enrichment to Arianna Huffington herself, if not to the cadre of free-lance bloggers who toiled without for years without compensation, to enable a generous pay-day redounding to her benefit alone.

On all this background I wrote my friend again, suggesting it was well past time he acted on his long-held awareness, that monthly AOL subscription fees were a wasteful expense drain for an inferior product that had long since been over-taken in the marketplace, and also that he had just experienced the last-straw disruption and inconvenience commonly inflicted by an outmoded service, pernicious in its obsolescence.

As for extending the metaphor -- where have we heard this before?

The answer of course is that for the last twenty-five years, nothing but in-bred regulatory inertia and supine user acquiescence have propped up the standard auditor’s report on a financial reporting model that is no less obsolete than that of AOL.

Nobody reads an audit report – nobody attends to its commodity language. No transactions of significance turn on its content, which can be purchased without qualification by any company short of bankruptcy, no matter its dubious reputation or parlous condition. No candid banker or institutional investor, claiming to act in other than a herd-oriented role, will admit to laying value on a document behind which individual due diligence is obligatory.    

While on the contrary, retail investors lack the time, tools and expertise to de-construct the arcana of financial reporting standards too complex and multifarious for the comprehension of mere mortals. 

Finally, the costs to consumers are indirect, buried far from view and only moderately painful. And with self-interested players having their own reasons to prefer a system subject to their gaming, the indifference of the sluggish acts like gum in the gears of evolution and innovation.

The death of AOL’s dial-up business has been an inevitability ever since it became common knowledge that the cost of internet connectivity would approach zero. So came the recognition by CEO Tim Armstrong, that evolution for the sake of survival was least expedient. Whether achievable, time will tell -- although the immediate post-merger firing of 900 AOL employees suggests an imminent re-play of the old maxim that a strategy of “shrinking to greatness” is next to impossible.

As for the equally obsolete model of financial reporting and assurance, the spam being broadcast to user communities in the form of traditional annual reports and auditors’ opinions remains unchecked, if only for the moment.

To paraphrase the health warning on my friend’s inadvertently intrusive Canadian web site – seek immediate medical relief for any audit report that generates excitement lasting more than four seconds.

 

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