Re:Balance -- Jim Peterson

The Big Four Accounting Firms' Financial Tipping Point -- Time for a Fresh Look

How quickly time does fly. It’s been three long years since my last review of the litigation “tipping point” that would disintegrate the fragile business models of the Big Four accounting networks. 

It’s time again. And not just because of the regulators’ threatened imposition of mandatory auditor rotation and other limitations sure to impair the quality of audits -- both PCAOB Chairman James Doty and EU markets commissioner Michel Barnier (see his November 30 press release, FAQ’s and provisional directive).

Those worrying about the incomprehensibility of Barnier’s financial and market thresholds for splitting off the non-audit practices of the European networks or injecting second-firm auditors (here) are looking in the wrong place.

That’s because the inventory of multi-billion dollar financial scandals in the firms’ client lists is constantly refreshed: revelations this fall alone include Kweku Adoboli’s roguish trading at UBS, the $1.2 billion shortfall in customer accounts at MF Global, and the decades of under-performance at Olympus concealed by dubious advisors’ fees.

Back in September 2006 – to re-set, and for new readers -- a report by the consulting firm London Economics to then-EU markets commissioner Charlie McCreevy (here) modeled the threshold limits of financial pain that would be tolerable to a Big Four UK partnership, before its owners would withdraw their loyalty and their capital and vote with their feet[1] – a process that would, unfortunately, lead to the rapid disintegration of the entire franchise of privately-provided assurance to the world’s large public companies.

I applied the London methodology to the global financial results published by the Big Four, in December 2006 and again in October 2008 – yielding calculations that, however ominous, were never disputed, nor have they been displaced by alternate models or methods.

It is poorly appreciated, if at all, that the private partnerships comprising the large international accounting networks operate with razor-thin levels of capital, for three reasons:

• Their major working capital needs – employee salaries, space costs and technology and methodology investments – are financed out of the fire-hose cash stream of client-derived revenues.

• The tax codes of the largest economies are cash-based for partnerships, creating a powerful incentive for the firms to distribute current income out to the partners to match with their tax liabilities.

• And, there being no alternatively valuable need or opportunity for the deployment of excess capital under the firms’ current business models, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding pens.

Latest available figures for the Big Four indicate total annual global revenues of some $ 102 billion.[2]

Applied to those figures, the model indicates that the break-up threshold for any one of the Big Four firm’s litigation “worst-cases” would be in the range from a maximum of $ 6 billion down to $ 2.2 billion, if viewed at the global level.

That is a considerable increase from the earlier numbers, owing to the great leap in total big-firm revenues in the intervening years.

But cautions remain. Most importantly, cohesion of the international networks under the strain of death-threat litigation, or the extended availability of collegial cross-border financial support, cannot be assumed. Arthur Andersen’s rapid disintegration in 2002 with the flight of its non-US member firms is illustrative.

So it is necessary to look at the bust-up range based on figures alone from the Americas, the most hazardous region. If left to their local resources, as was Andersen’s US firm, the disintegration range shrinks, from a maximum of less than $ 3 billion down to a truly frightening $ 675 million.

Amounts at that level compare ominously with the litigation settlements recently extracted from the larger debacles of the last decade – examples led by Bank of America’s post-Countrywide mortgage-securities settlement of $8.5 billion (here) and including such investor settlements as Enron ($7.2 billion), WorldCom ($6.2 billion) and Tyco ($3.2 billion) (here).

But those amounts were only available because inflicted on the investor-funded balance sheets of the corporations contributing to the settlements – resources not available to the private accounting partnerships. And they are even more darkly comparable with the exposures looming in the pending claims inventory.

True, in recent months the large accounting firms have enjoyed remarkable success in disposing of large litigations for modest sums – examples include KPMG resolving Countrywide for $ 24 million (here) and New Century for $ 45 million (here), and Deloitte settling Washington Mutual for $ 18.5 million (here).

However, hope for the indefinite continuation of such forbearance on the part of the plaintiffs is not a strategy, but only a wish.

As the catastrophic impact of “black swan” events makes clear, it only takes one. And at that tipping point, all the marginal fiddling by Barnier, Doty and their ilk becomes academic.

 

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[1] To summarize the model, as I wrote previously, “The original London study assumed that, in a highly-charged crisis environment dominated by the pressure and publicity of a massive adverse litigation result, critical numbers of partners would defect, so as to put a firm into a death spiral, if faced with a profit reduction of from 15 to 20 percent and extending over three or four years.”

[2] Deloitte, as of May 31, 2011: Global revenue $ 28.8, Americas $ 14.3 (here).

   Ernst & Young, as of June 30, 2011: Global revenue $ 22.9, Americas $ 8.9 (here).

   KPMG, as of September 30, 2010: Global revenue $ 20.6, Americas $ 6.4 (here).

   PwC, as of June 30, 2011: Global revenue $ 29.2, Americas $14.1 (here).           

 

 

 

A Case for Mandatory Auditor Rotation? Sharp-Eyed Students Have a Look

With comments due next month, the concept release on mandatory auditor rotation, issued by the Public Company Accounting Oversight Board on August 16 (here), provided an irresistible mid-term assignment for my class in Risk Management. 

It’s been stimulating this fall, to be with a group of students from the law and policy schools of the University of Chicago. We examine the sources of bias, misperception and flawed analysis in the behavior of those charged with governance and leadership – in business, politics and regulation. PCAOB chairman James Doty’s promotion and affection for auditor rotation was a natural.

Ask a group of inquisitive students to find the three central themes in an assignment, and collectively they will find all six – but in this exercise, their insights are on target.

First, in the venerable economics-oriented tradition of the U of C, where the words “opportunity cost” could be etched on a microchip installed in the frontal lobes of new arrivals, it’s no surprise that the PCAOB’s sketchy attitude toward the costs of rotation caught their attention. An example:

“The PCAOB’s proposed new rule and request for commentary seems to be based on a paucity of actual hard evidence and numbers.  (T)he trigger is …“financial scandals at Enron, WorldCom, and elsewhere,”… (but) the PCAOB does not attempt to estimate (even roughly) the costs of those failures, but they acknowledge that any increases in regulation will impose added cost to the financial system.  It might have been helpful for PCAOB to try to offer some way to balance the likely costs and benefits from alternative approaches.”

Going far beyond their skepticism about the doubtful extent of the PCAOB’s economic savvy, however, these samples of the observations of a classroom of curious students show their shared grasp of the agency’s pursuit of a preconceived agenda:

“By framing the issue as a problem with professional skepticism and objectivity, the release seems to ignore other possible explanations for auditing failures, even in the absence of any empirical evidence linking audit failures to the influences it believes is responsible.”

“It appears the conclusion has already been reached that errors and failures are a result of the relationship between the auditing firms and their clients, where relationships and failures are positively associated. This anchoring or early commitment to the source of the problem changes the entire frame of the argument…. The induction that because clients and auditors have long relationships, and there are issues, does not mean that there are issues because of the length of their relationship.”

“Failures of auditing accountability have not been decisively linked to auditing tenure.  There is something of a problem of absent evidence here—though the linkage might seem intuitive, there have not been reliable studies performed to examine alternate explanations.  Thus, the agency is reasoning from a lack of disconfirming evidence.”

“The primary flaw made in the Concept Release is an assumption of causality between audit company tenure and audit failure … likely induced by availability bias, confirmation bias and shortsighted shortcuts… Investigators see numerous longstanding relationships—this has led to an availability bias and confirmation bias—since longer relationships are a norm in this industry.”

“The WorldCom and Enron scandals are the “black swans” that … should be considered when creating policy decisions. However, it would be a mistake to believe that all swans are black because you have seen a black swan.” 

The well-observed “absence of evidence” is only the beginning, however, as put this way:

“The flaws of the Concept Release are not only limited to frame blindness; … the fact on which they relied are biased with the more common traps: anchoring, availability, representativeness, lack of evidence and confirmation bias.”

And the unproven issues of relating to competition and auditor choice were flagged:

“If the market for auditing services is not “competitive” in the economic sense, this should diminish the expectation that a policy of forced rotation would leave businesses with adequate substitutes available for each “round” of auditing.”

One student even got to a nuance on incentives that the PCAOB itself has breezed right on by – the flawed assumption that “Rotating auditors is preferred because an auditor would be incentivized to ‘clean up’ the books knowing another company would look at them when they took over.” Instead, “knowing they will be leaving…the auditing firm could be less incentivized to ‘clean up’ the books, as it would no longer be their responsibility.”

This last insight wanted only the next step, that a successor auditor under a rotation mandate would have no more incentive to raise issues with its predecessor than the other way around, since it will have inherited the obligation to resolve the issue and be responsible for it – the classic deterrent to quality that “If you raise a problem, then you become the problem.”

I could not conclude any better than as one student most pungently put it:

“The remedy (of mandatory rotation) comes not from informed research about the problem but from a formulaic dealing with problems of integrity and a Band-Aid based in biases.”

 

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Lessons in Risk Management: A Broken Clock is Never Right -- It's Just Broken

The national recalibration caused by this weekend's fall-back to standard time is a reminder of the cliché recently repeated by a friend, that: 

“Even a broken clock is right twice a day ….”

Or so it is supposed, for the proposition that some information is better than none at all.

I will spare my friend's identity, since this is not personal. But as studied by my students in Risk Management, it is vitally important to scrutinize both what you know and what you don’t – and not be misled into missing the difference by the invocation of familiar but unexamined verities.

I surveyed my students – who with their PC’s and iPads and smartphones are carrying around an average of 2.5 devices providing them with the hour – of which only a fraction are readable by way of little hands pointing at a circular array of twelve numbers on a dial.

It’s the same in today’s public life: the handsome golden landmark clock in Grand Central Station is an anachronism, superseded by the blinking digital screens of the airport flight announcements, the pulsing scoreboard lights of the sports arenas and the obnoxious talking panels of the typical office elevator.

Even in the classroom for my MBA course, a sleek modern rectangular digital time screen hangs above the door.

Here’s the point: when broken, the ubiquitous digital clocks simply go blank. There is no sense in which, when non-functioning, a dark and empty display can ever be “right.”

So the claim is incomprehensible to anyone raised in a world of digital time-pieces. Baby-boomers are likely the last at risk of being led astray, having grown up with (and still using) analog time-keeping machinery.

At no time in the diurnal cycle is any meaningful time guidance offered by a crashed computer or an uncharged cell phone – or, for that matter, a dead microwave or DVD player or any of the myriad of appliances now equipped with digital clocks on which generations younger than the fogies rely.

The “right twice a day” assertion also suffers a more subtle flaw: How do you know? The question of “right-ness” is only testable by reference to an outside source. Looking at the hands of a broken clocked stopped at the classic “ten-to-two,” you may suspect being late for lunch.  But you can’t know without a working alternative. Whatever its format, no informational value is added by viewing the face of a dysfunctional clock.

The inquiry really needs to go down another layer, though, to the reason for calling on the cliché in the first place.

Examples abound where a little information is actually worse than none, especially where users are lulled into a false sense of security and over-confidence.

Unmarked and narrow country roads suffer a lower rate of fatal vehicle accidents, for example, than high-speed expressways, even if the latter are fitted with lane markers and rumble strips and crash barriers, precisely because the rural lanes demand high degrees of focus and attention, prudence and speed discretion.

Equally, day traders seduced by computer-generated graphs and charts of stock price activities are lured into the misapprehension that the flood of data is a reliable measure for predictability, only to crash and fail at the rate of amateur punters in a casino.

And on a global scale since 2007, the road to financial ruin has been littered with the reputational corpses of those who mistakenly believed that the quants’ “value-at-risk” models and their off-spring sufficed to support their portfolios of exotic financial products – among them, Jimmy Cayne of Bear Stearns, Chuck Prince of Citi, Dick Fuld of Lehman Brothers and most lately, Jon Corzine at MF Global.

Which is not to say that there is nothing at all to learn from a clear-eyed acknowledgement of the limits on the knowable. But more likely than an unexamined repetition of a maxim that is both conventional and therefore probably wrong, let the inquiry seek wisdom from the more humble perspective of the counsels of caution. 

PS: An invitation: send me your suggestions for other clichés worthy of attention and deflation. Thanks.

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