Re:Balance -- Jim Peterson

Tipping Points: The Financial Fragility of the Big Four (Part Two)

“None of us has a clue.”

The late William McDonough, first chairman of the Public Company Accounting Oversight Board in the US, asked in 2005 what the authorities would do in the event of another global accounting network failure.

My guests posts this week on Francine McKenna’s substack, The Dig (here, here and here) –- posted on this blog here, here, and today -- update this question, first examined in 2006 and periodically refreshed:

What size financial hit could a Big Four accounting network withstand and survive, from litigation damages or an enforcement penalty on the scale of the fatal blow that Enron inflicted on Arthur Andersen in 2002?

Applying a behavioral study done in 2006 to the Big Four’s reported data on global and country-level revenues, that evaluated the willingness of Big Four partners in the UK to sacrifice current income to save a firm from a financially ruinous litigation judgment, the results are ominous:    

None of the Big Four accounting networks have the financial resources or organizational stability to survive their largest litigation and law enforcement exposures. If another of the Big Four should fail, the entire model spirals into collapse.

As built out in the first installment, calculations under the 2006 study indicate that litigation-driven tipping points for the Big Four at global level would fall, on optimistic assumptions, well below the level of a firm’s total one-year global profits.

Those limits would however be subject to further erosion based on less optimistic assumptions as to partner behavior, as well as doubts as to the ability of a network to maintain its cohesion and integrity under such challenges, and most especially from a local-country perspective, where the resources to meet a claim measured in the billions (whether dollars, pounds or euros) would be lacking.      

Three topics remain to be covered and addressed here –- the basic issue of the structures of the global networks, the myth that insurance would somehow shelter the Big Four from existential threat, and the disruption that would disintegrate the entire model if another large network suffers the fate that befell Andersen.

The Grim Reality of the Calculations

Bearing on the ominous estimates that emerge from the data just summarized are the structural realities of the Big Four, poorly appreciated, if at all: that their make-up as networks of private partnerships operate with razor-thin levels of capital. That is for three reasons:

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

• The income tax codes of the largest economies are cash-based for partnerships, creating a powerful incentive for the firms to distribute substantially all their current profits out to the partners, speedily and timed to match with their immediate personal tax liabilities.

• There being no alternative need to deploy excess capital or outside investment, under the firms’ current business models, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding tanks.

Above all, it must be remembered that the partners of the large firms are not indentured, nor on-call hostages to the assumptions of the politicians and regulators of the world’s large economies. Put under enough stress, they will act to protect their interests.

Financial Resources –- Credit, Liquidity, and Insurance

The Final Paper of the UK’s Competition & Markets Authority (April 18, 2019 (¶ 7.13)) stated optimistically that:

“Deloitte told us it had access to lines of credit from financial institutions to manage working capital, and it had insurance cover to guard against fines and litigation.”

Not so. As shown by the experience of Andersen’s collapse, neither a firm’s working capital nor its insurance are remotely sufficient, measured against the magnitude of a claim on a life-threatening scale.

As for the credit-worthiness of a network under threat, the unraveling of a firm’s partnership structure, as occurred virtually overnight with Andersen and as was foreseeable under the London Economics study, would prompt an immediate shut-down of lines of credit geared to a firm’s loss of on-going viability.

That effect would be dire because, as the financial statements of the UK firms reveal, their readily available resources are limited, for reasons earlier discussed here. As reflected in the UK firms’ latest filings with Companies House (£ billions):

 

                            Partner Capital                     Cash and equivalents

Deloitte                      £ 256                                       £  608

PwC                              274                                        1,128

EY                                 170                                           385

KPMG                           258                                           465

All very well, for routine operations in normal times, when the firms’ working capital needs are modest because their businesses run on collection of their client receivables. Instead, a comparison with, say, the 2018 settlement by PwC’s US firm of the FDIC’s $ 635 million award of damages relating to Colonial Bank, for $ 335 million, indicates the liquidity peril that a large enforceable judgment or settlement would entail.

As for insurance, the effective absence of the commercial insurance sector from coverage of the large firms at the current and greatly expanded catastrophic levels, and the limited protection of the Big Four’s own self-insurance by way of loss-shifting to the future generations of their younger partners, are underappreciated factors in this entire calculus.

On the commercial side, to use the colorful off-the-record metaphor of an expert industry source, not only is the Big Four’s patchy insurance blanket far too small to cover the liability bed they have chosen to lie in, but also -- as a consequence of large and growing deductions and retentions -- it is thin, frayed and full of holes.

The reasons are readily available, starting with the misalignment of the Big Four’s large-case litigation profile with the insurance industry’s three required suitability conditions, none of which can the auditors satisfy:

• Diversity of claims –- as is the case in large portfolios such as human lives or auto accidents, but absent in a market of only four participants.

• Predictability of occurrence –- again measurable by actuaries if given a suitably large sample size, but absent for the auditors since catastrophic risks exist with the audit of any public company large enough to house potential misfeasance at the multi-billion-dollar level -– history proving that those will erupt with inevitable frequency despite all attempts to achieve the unattainable goal of “zero defects.”

• Quantifiability of exposures –- also without limit under legal regimes allowing claims for damages on a “joint and several” basis up to the total value of a failed corporate enterprise.

It is not good news that the insurance industry’s readiness over past years to support the accountants has long since been outstripped by twenty years of massive escalation in the size of the “worst” cases. Examples start with the $ 67 billion bankruptcy of Enron itself, followed shortly by the revelation in 2004 of the € 20 billion hole in the balance sheet of Parmalat in Italy -– both ahead of the far larger collapses of the institutions that failed across the globe in the financial crisis that began in 2007, and now extend to such failures as Carillion, NMC, Wirecard and Evergrande.

The cyclicality of the commercial insurance market –- subject to finite limits despite the popular assumption that somehow “insurance is always available” -- now finds greater appetite to cover airline crashes and hurricane damage. For the auditors, even today’s ragged capacity would ill-protect against the chilly horrors of the inevitably recurring new litigation nightmares.

Moving on -- above whatever amount of commercial insurance cover may be available, what self-help is there for the Big Four in the build-up of reserves held by their own “captive” insurance operations?

For a start -- at their global level, access to international network resources by a failing national firm would be hostage to the survivability of the cross-border financial commitments of the network’s other members. Again, that optimistic assumption proved illusory in the speedy collapse of Andersen’s global network in 2002 -- appearances of its members’ ostensibly robust and mutually enforceable contractual commitments notwithstanding.

As one of the authors of Andersen’s uniquely cohesive but ultimately fragile worldwide organization put it, “the structure was at best a treaty. And as a treaty, it was only as stable as the continued trust and commitment of all of the separate country practices.”

And moving further on -- whether captive insurer capacity is measured globally or at the local firm level, as put by the London study (p. 93), “insurance capacity is limited by their (partners’) capital,” such that “captive insurance is simply a timing mechanism that smooths the effect of claim payments…” (emphasis added).

In other words, while “captive” operations may qualify as “insurance” within the scope of the industry’s definitions, they effectively operate only as a means of shifting financial contributions between generations of partners. For purposes of tipping point calculations, if partners were called upon to satisfy a massive litigation claim, their readiness and tolerance to re-finance a firm’s future-looking insurance structure, rather than under-writing payments directly to claimants, would only involve the re-direction of the same amount of their individual financial sacrifice.  

That being the case (p. 104), “once the limits provided by the captive have been exhausted, the burden of a large-scale settlement has to be borne by the firm and its partners.” In blunt terms, and as previously discussed, the limiting issue (pp. 104-5) is “the reduction in income that typically partners would be willing to tolerate before jumping ship and endangering the viability of the firm.”

As has been outlined, the readiness of large-firm partners to bear that burden is neither limitless nor satisfactory to assure their firms’ ability to survive. 

The Next Collapse: Not Four to Three, But Four to Zero

Finally, loss of another of the Big Four would throw the entire system into chaos — for lack of auditor choice and readiness among the survivors to stay in an unbearably risky business.

As noted in the first installment here, it cannot be assumed that, just because the surviving Big Four were able to absorb Andersen’s clients back in 2002, along with the staff necessary to serve them, a Four-to-Three scenario is also viable today.

In fact, while Andersen’s failure caused a creaking realignment in which all large companies eventually found a successor auditor from within the surviving Big Four, that quartet today is down to its critical minimum. The uneven concentrations of personnel, market share and industry expertise around the world’s largest economies, the politically imposed restrictions on auditor choice due to outmoded concepts of independence, and the post-Andersen fragility of the large networks combine to show that the current tetrapoly structure is irreducible.

Despite Separation, the “Linchpin” Effect

The 2006 London study for EU Commissioner McGreevy was explicit on the broad global consequences of a failure:

“While the demise of a non-key firm may entail some reputational loss for the network as a whole, and potential problems for the firm’s clients in finding a suitable and available replacement audit firm, it will generally not result in a wide-spread disruption across many capital markets.

“In contrast, the demise of a linchpin firm in a network may imperil the whole network and thus have wider repercussions for capital markets in Europe.”

As is now playing out with the Big Four networks separating their member firms in Russia under the international array of Ukraine-based sanctions, a Big Four network can survive the loss of a member firm in one of the world’s smaller economies, where the scale of client operations would allow a network either to replace personnel and resources or to engage a smaller firm to audit a local subsidiary. The challenge would be altogether different if a Big Four network lost its firm in a country of substantial size –- at the level of the G7 economies and perhaps a handful of others -- one of its critical “linchpins,” on which network survival would crucially depend.

The vision should be clear: a Big Four network that loses its member firm in such a country could neither perform the leading and consolidation work for its global-scale clients based there, nor audit client operations in that country to support consolidated reporting by a large company headquartered elsewhere. Local replacement resources would be scarce, unavailable, or unqualified; conflicts and other limitations would disqualify other Big Four firms, whose appetite to take on a single-country subsidiary would be modest; while smaller firms would lack the qualified personnel and industry expertise to serve global-scale enterprises.

Concisely put, the “linchpin effect” involves a darker aspect of the unique dominance of the Big Four of the audit market for large global companies -- if a Big Four network cannot operate everywhere, it cannot operate anywhere.      

Further to the Attitude of the Regulators

The CMA’s Final Report proceeded on the blithe and erroneous assumption, that the impact of a Big Four failure would be mitigated by movement of partners and clients and the mobility of audits to other firms, including what it calls the “challengers,” or the enforced continuity of its practice while showing symptoms of failure (¶ 7.7). The reasoning does not provide support:

• The collapse of Andersen, given the difference in current conditions presented by a possible Four-to-Three scenario, remains relevant and is to the contrary.

• Nor is there logic to the CMA’s circular position (Update Paper ¶ 3.137 and Final Paper ¶ 3.176) that the Big Audit model would be resilient against a catastrophic failure because of the regulatory requirement for audits. Imposing a legal obligation does not assure the availability of the means to comply. Official impositions are not self-executing. In a “collapse” environment where supply has become constrained, the existence of an official “requirement” for audits would be no more realistic or achievable than a misguided regulation that all audit reports be signed by a left-handed redhead. Collapse on the supply side would instead only leave the entire system out of compliance –- audits not then being available from any source or at any 

The CMA suggests that provisions of some sort would arrest the flight of personnel from a large firm in the process of collapse. Its Final Report (¶ 7.21(d)) contemplated an undefined world in which a regulator would “provide certainty to the markets and transparency to staff to prevent a ‘run’ on a distressed audit practice” (emphasis added).

Experience is to the contrary. The Andersen worldwide structure unraveled at a pace that was neither manageable nor stoppable –- both its management and the authorities were as hapless as all the king’s men and horses confronting the fall of Humpty Dumpty.   

Attempted regulatory constraints on personnel mobility would be of doubtful enforceability in any event, while government-subsidized financial inducements could never overcome the looming threat of personal financial ruin that could be inflicted by an Enron-scale disaster. 

Conclusion

To recap. The calculations offered here have never been disputed—ominous and shockingly small as they are. No other alternative models or estimates have ever been offered. Nor is there any credible claim that a political or regulatory solution is achievable.

Although a public discussion would be illuminating, Big Four financial fragility has been a “third rail” topic. Little wonder that the only available validation is on deep background — reluctantly given at that — which never rises to a position on the record, but suggests that if anything the cited numbers are too large.

One more down, and they all go down. To survive, the stability of the entire wobbly structure of the Big Four rests on the continuing survival of all of them, including the weakest.

Although this picture is neither cheerful nor optimistic, it should not be taken as the counsel of either cynicism or despair. Grave and pressing as are the challenges to the survivability of the Big Audit model, they are within the grasp of the entire community of interested parties.

Denial and evasion do not, however, comprise a strategy for action. That awaits informed good-faith participation on the part of all players, including a readiness to recognize and accommodate the self-interests of each in service to a process of evolution that can only proceed on holistic and comprehensive terms.     

 

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Book Announcement: "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms"

For those who may have wondered -- my reduced schedule here in recent months had a reason: completion and readying for publication of my book, "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms".

I am pleased and proud that the book is next in the Emerald Publishing Group's series, "Studies in the Development of Accounting Thought," edited by Gary Previts, E. Mandell de Windt Professor of Accountancy at Case Western Reserve University, member of the Accounting Hall of Fame and past president of the American Accounting Association.

Its scope -- bringing together themes long explored here and going back to my column in the International Herald Tribune -- is summarized in this from Emerald:

The post-Enron disintegration of Arthur Andersen in 2002 reduced to the surviving Big Four the number of international accounting firms that audit nearly all of the world’s largest public companies -- Deloitte, EY, KPMG and PwC.

 Despite their strengths -- market dominance, double-digit annual growth in non-audit services and continued revenue expansion to a global total above $ 120 billion in 2014 – the viability of the Big Four and their business model faces serious threats:

• Widespread dissatisfaction with the standard form and language of their core product -- the traditional “pass-fail” auditor’s report.

• The persistent “expectations gap” between their perceived performance quality and the stated desires of information users.

• Difficult relations with regulators and oversight agencies.

• And especially, the questionable ability of the Big Four and their partners to survive a “black swan” financial shock – a litigation judgment or law enforcement sanction on the scale that destroyed Arthur Andersen.

"Count Down" looks at the complex challenges facing the Big Four, questions the feasibility and achievability of the various proffered “solutions,” and proposes an evolved model for Big Audit that would be both sustainable for the large firms and fit to serve the capital markets of the 21^st century.

“ This book lifts the lid on the story behind the financial statements of the world’s major companies. If you want to understand the system that is allegedly validating the reported data - and why the system is a clone of the Maginot Line - expensive, obsolete and irrelevant - read on. Weak as the present system is, there is a solution. It will take a major change in regulatory attitude and a fresh approach, unfettered by history. The section on the imaginative use of Big Data is worth study by itself. “

     -- Duane R. Kullberg, Arthur Andersen & Co., S.C. Chief Executive Officer, 1980-1989

“Illusions of safety in size doomed allosaurus, empires, and auto makers. In his Count Down, Jim Peterson examines the fragility of the ineffectual audit regime, and the imminent threats to its survival. Peterson combines the insider’s knowledge with an outsider’s critical but sympathetic perspective and suggestions in this fascinating and insightful volume—a must-read for accountants and students of accounting.”

     -- Shyam Sunder, James L. Frank Professor of Accounting, Economics, and Finance, Yale School of Management

Scheduled release date is October 15. For information, and to order:

     From Emerald Books

     From Amazon

Please share with your friends and colleagues. For questions and other inquiries -- and for Emerald's pre-publication discount -- please write me: [email protected]

Mandatory Auditor Rotation -- The PCAOB Bites Off More Than It Can Chew

            “The unspeakable chasing the uneatable.”

Oscar Wilde’s description of English fox-hunting captures the spirit of the two days staged in Washington on March 21-22 by the Public Company Accounting Oversight Board – in aide of illumination on mandatory auditor rotation.

(The PCAOB’s release of August 2011 announced its initiative; it links to the overwhelmingly negative public reaction. My own long-standing pessimism is partly here, here and here.)

Thankfully unable to attend, due to classroom commitments, I salute those brave and durable enough to have done – although the tedium of the webcasts accuses anyone without handsome compensation of not having enough to do.

Which is to say, the offerings from the 47 speakers crammed into the panel sessions were entirely predictable. The maxim was reinforced conclusively that the amount of intelligent substance in any agency proceeding is an upwardly-bounded constant -- the only variable being the number of witnesses among whom it is thinly spread.

Examples included the panels of academics and “investor representatives,” whose perfervid but anecdotal pro-rotation rhetoric was untroubled by the continuing absence of any relevant empirical evidence associating auditor tenure with audit quality; Paul Volcker’s plangent if irrelevant reminiscence of his brief and inconsequential association in 2002 with Arthur Andersen’s terminal state; and Jack Ciesielski’s attempt to revive the notion that insurance might backstop the auditors – a fantasy lacking credibility and long discredited (here) by the insurance industry’s manifest lack of interest.

Careful assessment of the PCAOB house-party reveals neither an empirical case for mandatory rotation nor the supportive votes among its members – leaving this question:

What will political pressure oblige the PCAOB’s members to bring forward by way of action?     

Between the poles of the speakers' antagonisms, there are the faint outlines of plausible mid-range approaches:

To start – noting a plain truth by former SEC general counsel David Becker, that individual cases for mandated auditor rotation are “intensely situational”– support now emerges for the PCAOB’s use of enforcement-based mandated rotation (e.g., Harvey Pitt).

Well -- “right on,” but also “about time.” Having written to this effect way back in August 2011 (here), I put it this way:

“…In a specific case, if the PCAOB can sustain its proof that long audit tenure was causally related to its definition of “audit failure,” it could include rotation in its toolkit of post-inspection sanctions.

“Since the PCAOB looks annually at a sampling of engagements for each of the large audit firms, and claims to target its inspections on the basis of perceived engagement risk and exposure, the agency’s experience base should bring to light cases – if any – where audit quality might be affected by length of tenure.  

“In which case, rotation could be proposed, and if necessary, imposed.” 

The other way forward comes in two flavors – either of which would allow PCAOB chairman James Doty to declare victory; would be tolerable to the profession; and, unlike mandated rotation, would actually be achievable in the large company audit market.

The first would be by way of periodic mandatory re-tender, with the incumbent auditor eligible to be re-engaged. The estimable Bob Pozen, one of chairman Doty's "rock stars," proposed 14 years (here), so as to allow for three individual partner rotations. Others proposed far shorter periods, although five or seven years would be too short, causing the profession to spend endless time and waste prodigious sums in a musical-chairs chase for business.

Compromise should be possible. If potential replacement auditors had the commercial choice of giving up ancillary services for their clients – tax, consulting, valuation – in order to be eligible to take up the audit, the market itself would determine the range of choice and competition. That has to be better than leaving such bright lines to be drawn under the dim vision of the regulators.

The second alternative places focus on the responsibilities of corporate audit committees – supported by former SEC chairmen Richard Breeden and Harvey Pitt among many others. That body would be obliged periodically to justify the continued engagement of a long tenured auditor – a process of “comply or explain” -- not difficult for a good quality committee.

Failing which the PCAOB, challenged to focus its inspection attention on long-lasting relationships, could determine that a dysfunctional audit committee amounted to a material corporate control weakness, justifying the requirement of a re-tendering.

I have crawled out on numerous shaky limbs, and survived. So I am prepared to predict here that some variant of these ideas will emerge at the seemingly endless end of the PCAOB’s process.

(Other and deeper problems would remain untouched, much less unresolved by this outcome, unfortunately, such as the basic value and usefulness of today’s accounting and reporting model itself, the relevance of audits, and the very existential viability of the private audit franchise – all subjects postponed to other days.)

Meanwhile, audit committee leadership on either re-tendering or “comply or explain” would not cause the world of audit to come crashing down. The actual effect would be modest at most.

Which in a world of knee-jerk critics and short-sighted regulators would be no small thing -- and one the community of financial statement users could very well live with.

 

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The European Commission's Green Paper on Audit: After the Posturing, an EC Agenda for Real Progress

Say this for EC Internal Markets and Services Commissioner Michel Barnier’s call for public comments on his October 13 green paper, “Audit Policy: Lessons from the Crisis”:

No sooner had I sent in my own ill-tempered two euros worth – here – than my readership statistics showed a serious spike from addresses across the European Union. There’s real interest out there!

Having taken M Barnier to task, I was rightly challenged by readers to stop complaining and be constructive. So with a response deadline of December 8, this is to invite all those concurring that more is required from Brussels than a feckless and ill-informed exercise in redundancy, to register their views at the EU site – here.

The message is this:

All that needs be known is already at hand, to build the agenda for a really effective discussion on the re-engineering of a sustainable audit function to serve the world’s global-scale companies.

It would have these three components:

• Certain basic truths would be taken as established.

• Any further reference to the over-debated but impractical or unachievable “non-starters” would be barred.

• Focus would be on the handful of truly difficult, challenging questions – on which views would differ profoundly, but which are inescapably important to any progress.

In the first category, there may not be consensus on all details, but these propositions are basically beyond debate:

• Other than for purposes of statutory compliance, the standard one-page audit report no longer serves a function that justifies its cost to issuers or the exposure it imposes on auditors. Evolution to new forms of assurance is essential.

• The concentration of large-company audits among the Big Four is down to a critical minimum. A three-firm model is unworkable; failure of any one will disintegrate the entire structure.

• The organizational and capital structure of the Big Four leaves each one exposed to an unsustainable shock, from regulatory or law enforcement proceedings, or a civil litigation outcome in the $ 1 to $2 billion range.

• Regulators and politicians lack the vision, authority or means – separately or collectively – to rescue and sustain a large accounting firm once a shock tips it into a downward spiral.

In the second category, the catalog of “non-starters” includes:

• Liability “caps”, whether monetary limits or allocated percentages of responsibility.

• “Break-up” of the Big Four firms – an act of aggression having neither a rationale nor a basis in law. 

• The emergence of new global-scale entrants to the Big Four’s audit market, whether by merger, subsidy or organic growth. 

• The injection of outside investment into the Big Four’s capital structure, or alteration of existing ownership restraints.

• Mandatory auditor rotation or replacement.

• Contingency plans to replace the management of a firm under existential threat.

• Re-introduction of genuine forms of private insurance, by way of “catastrophe bonds” or otherwise.

Finally, to table a selection of the hard but unavoidable questions:

• What are the forms of assurance that issuers and users would actually value and pay for, and what structural changes are required – competitive, organizational, legislative and regulatory – to enable the evolution of a profession capable of meeting those needs?

• What form of regulatory oversight, inspection, enforcement and discipline would achieve a sustainable balance between investor support and protection and an audit function that is both disciplined and robust? In particular, what is the necessary form and amount of financial involvement of government – whether an investor protection fund, insurance of last resort or otherwise?

• Under a newly-structured audit delivery model, and with a comprehensively refreshed legislative mandate, what are the proper limits and guidelines on the scope of services deliverable to audit clients, and what re-visiting of concepts of auditor independence and conduct are indicated?

The envisioning of a symposium devoted to such an agenda – much less its convening – has yet to occur. Until it does, and the process moves on to real substance, the stability of the current audit model and the four firms providing most of its delivery are both at risk.

 

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Drilling Down Into BP's Risk Management: A Process As Blown As The Well

“I never went to bed with an ugly woman. But I’ve sure woke up with a few.”

-- Country songwriter Bobby Bare

The failure of BP to “top kill” the Deepwater Horizon well brings to mind Blaise Pascal’s difficult question, how to strategize the unanswerable question whether God exists.

As he came out, to assume the positive and be right is marvelous, and to be wrong is of little effect; to assume the negative and be right is no worse than neutral – but to be wrong is damning.

Looked on as a matter of risk management – rather than as a much-debated philosophical or spiritual conundrum – Pascal’s challenge sits on top of the list of lessons from the events just ahead of the catastrophic blow-out in the Gulf of Mexico.

That is, if it were a final examination question in my MBA class – where we search for the lessons from failures in decision-making across a broad range of business and personal activity -- it would be hard to improve on the Deepwater Horizon disaster. The catalog of avoidable errors in analysis and performance is long and troubling – for example:

• Increased safety measures can mask heightened risk, especially where early signs of trouble are ignored as “close calls.”
• Increased complexity of technology alters the risk profile at the frontier of safety margins. 
• Management over-ride of on-the-spot warnings discourages honest communication and conceals bad news under the pressure to deliver success.
• Group-think and herd behavior are exacerbated by the over-confidence that mistakes past achievement for future safety.
  

Briefly put, the central theme in BP’s failed process was the consistent mis-measure, in its concededly risky choices, of Pascal’s potential up and downside gains and losses – related to what the statisticians confuse us all by referring to as Type 1 and Type 2 errors.

Examples abound, from the modestly consequential to the highly destructive. Consider:

A driver is low on gas. If he chooses to stop immediately, he gains the certain security of a full tank, foregoing the possibility of a modest savings. Whereas, if he carries on in search of a station with a lower price, his maximum upside is a few dollars gained, but his downside is to be marooned awaiting rescue by the roadside, or worse.

Or this: The space agency NASA must decide whether a shuttle launch can safely proceed in cold weather. Postponement to a warmer day means a modest loss of time, for the sake of mission safety – whereas pushing for a “go” decision can at best achieve budget and reputational success, but only with the risk that the frigid conditions will cause an explosive failure of the rocket’s booster (q.v., the 1986 loss of the shuttle Challenger and the lives of its seven astronauts).   

How extensible are the lessons of BP’s questionable decisions – the use of a riskier well casing, under pressures of time and budget, or the premature substitution of lightweight seawater for heavier drilling fluid, under delays costing $500,000 per day (here)?

At the level of individual risk tolerance, consider two insurance scenarios: Taking a pass on auto collision insurance saves the premiums, and puts at risk only the replacement cost of a total wreck. But choosing not to buy long-term health care insurance runs the uninsured risk of a debilitating and devastatingly expensive illness.

Or for investors: excess portfolio concentration in pursuit of incremental performance ignores the question, “How bad could this possibly get?” – as learned to their sorrow by Bernie Madoff’s clients and employees with their savings in Enron’s retirement program.

Consequences vary. Pick a bad restaurant, and the only loss is an evening’s sub-standard dining. But fail to hedge a naked short, and the losses could be ruinous. 

Corporate risk management depends for success on similar decision-making dynamics: Is a bet-the-company strategy acceptable? Is it even recognized?

Whatever the assessments made by Bear’s Jimmy Cayne or Lehman’s Dick Fuld or Countrywide’s Angelo Mozilo, they mis-evaluated their exposures to disastrous downsides – no less than the bureaucrats of NASA or the over-seers at BP.

On the other hand, betting Pascal’s wager the wrong way risks the wrath of an angry deity – which in the long run may be worse.

 

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The Future of Goldman Sachs: Sound, Fury, and the Human Appetite for Risk

 

If correctly read, the thermometer on the temperature of the body politic suggests that the public fever of the last weeks on the SEC’s charges against Goldman Sachs has broken.

A reader expressed her cooled reaction to Goldman’s design of an exotic, tradable mortgage-based product on which the shorts and longs were symmetrically affected: “Why not – after all, that’s what they do!”

It’s not just Warren Buffett's avuncular cheerleading at the Berkshire Hathaway shareholders’ meeting in Omaha, however directly interested, or the related embrace of the mainstream media (for both, see the NYT’s Andrew Ross Sorkin on May 3, here).

More, the brevity of public attention proves again Samuel Johnson’s 18^th century observation that “nothing focuses the mind like a hanging” – whether the present dependent subject is the British Parliament, BP’s oil containment efforts or the Greek noose around the neck of the Euro.

As it moves off-screen, Goldman’s future does not depend on the usually attenuated inter-connections between Main Street and Wall Street. It will lie, rather, in the hands of law enforcement officers, whose reputation enhancement will incline them to nick off a pound of flesh or two and move on to resolution; legislators ready to take up other posturings; and, especially, clients and trading partners whose self-interest will be well served by Goldman’s robust survival.

Which, the more I ponder, is as it must be.

Populist outrage at the business model behind Goldman’s esoteric designs always lack emotional coherence – the unease of those uninformed and unfamiliar with the operation of complex financial products showing again that a little information can be worse than none at all.

As the behavioral academics say, it’s very much to do with how the issues are framed.

For one example: conventional reaction would likely be negative in response to an opinion poll, “Would you support wagering on the length of a human life?”

Yet that is the entire basis for the life insurance industry, which – no less than Goldman’s Abacus product – is in the long run (costs, time value and enterprise profits included) a zero-sum proposition. Large pools of underwriters’ capital wager on the uncertain but ultimate timing of the inevitable mortality of those on whom the bets are made.

And a broad range of legitimately insurable interests are required – it only being frowned upon to allow, for example, the sole care-giver of a fragile elder to take a large policy for his own benefit.

Likewise, while the disconnect between aspirations and responsibilities played no small part in the foundational irrationality of the credit crisis, ownership of a family home has been widely promoted as a virtue. Meanwhile, despite the faint odor of disrepute not unlike that sometimes attached emotionally to short sellers in the equities markets, a niche market for reverse mortgages develops, by which the home equity of aged owners is bought out under pricing based on lifetime occupancy and actuarial expectancy tables.

Even at the personal level, the comparison has always been striking between motorcycle riders in America – who dutifully keep to their lanes although exercising a libertarian right to ride bare-headed – and those in France, for whom helmet compliance is inviolate but so is the chance to careen around traffic and down the dividers.

All of which shows that variations in risk appetites are pervasive, ranging from the ubiquity of casinos and lotteries to the cultural variations in personal safety judgments to the stream of innovations in mitigation techniques – whether product safety devices or hedging derivatives.

So while the particulars of Goldman’s innovations would, and will, outstrip the comprehension of its outsiders – beyond the atavistic spasms of short-term insult at the sheer amounts of money involved – its fundamental instincts are no different from those broadly inherent in the animating principles of human society in general.

In other words, they are part of us.

 

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"Supplements" for the Baby Boomers -- A Generation for Whom Enough is Never Enough

A diversion from the usual -- motivated by a recent conversation about the Baby Boomers: that displaced bulge in the population who have distorted society since they overran the nurseries of the Eisenhower years.

For this group, “joint” and “hip” once invoked a sub-culture of beads and bell-bottoms -- now associated more with “replacement” and “physical therapy.” Drugs of choice are no longer recreational, but regulate their HDL and systolic blood pressure. The numbers now threaten to swamp the delivery of elderly care, health insurance and retirement security.

The context was a nightmarish encounter with the bungled processing by an over-burdened bureaucracy of an application for Medicare – the triply oxymoronic American “health insurance program” that provides the age-advanced with no less than four inter-locking forms of coverage – for hospitals, doctors and drugs, along with an opaque and effectively non-optional layer of “supplemental coverage” that fills in the gaps in the other three.

On reflection, the concept of “supplements” seemed thematic. Unsatisfied with historically normative levels of entitlement, the Baby Boomers have invented, demanded and consumed whole categories of newly-identified goods and services – an influence evidently to continue until the long-denied arrival of their generational demise.

Consider their pervasive impact across the culture:

As noted, individual enrolment in long-term and other in-fill health insurance overage is a strategically vital supplement, because available health plans are insufficient to protect against the devastation of a catastrophic illness.

With the erosion of social security and the depleting of their under-funded savings and pension plans, the Boomers are staying at work post-retirement – consulting or teaching or hosting at Wal-Marts – to supplement income levels no longer deemed adequate to underwrite the mega-house or the bass boat behind the truck.

In the schools, the Boomers’ privileged offspring – each already classified on demand as gifted and above-average – subscribe to supplemental tutoring, test preparation and counseling as they strive to game the systems of university admission.

More youthful populist hostility to the diversion of taxpayer bail-out funds be damned, whole business sectors depend on the availability of salary supplements – bonuses being deemed vital to the compensation plans of banks and investment funds.

In the pharmacies, what were once the accepted signals of advancing maturity are now attacked by supplements ranging from age-targeted vitamins and synthetic hormones to Rogaine and Viagra.

While in front of the bathroom mirror, the previously unexceptional effects of time and gravity are defied by supplements delivered by tube and jar, scalpel and needle. Contours and visages are re-sculpted by augmentation or reduction, and the percentage of authentic body parts becomes inverse to the seniority revealed by the calendar.

Profound conclusions from these symptoms may be elusive, but strategies do emerge:

• ·      Clearly, any politician who gets in the way of the Baby Boomers’ voracious appetites for supplements of all sorts will be trampled and left for road kill under the government-provided walkers and wheel chairs.
• ·      On the other hand, lobbyists will prosper who line up in favor of legislative proposals for the extension of benefits of all varieties.
• ·      And investors might expect to be smartly rewarded for adding to their portfolios the makers of titanium knee joints, D-cup gel inserts and implants for hairlines, lips and cheekbones. 
  

While “rock on” no longer refers to Woodstock or the summer of love, but to the nap-inducing motion of a chair on the porch.

 

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Auditors Missing in the Financial Crisis -- Readers Offer their Thoughts

To greet the new year, instead of a backwards look at a dreary 2009, this will revisit last month’s lively exchange, initiated by Francine McKenna’s provocative post of December 7, “They Weren’t There: Auditors and the Financial Crisis.” My response of December 13 is here, and hers of the 14^th is here.

Highly compressed, the gist of our mutual concern is, as Francine put it, “the auditors’ failure to be a force either before, during, or after the financial crisis.” The depressing explanation, said I, 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.”

Our invitation to a conversation drew forth an exceptional level of reader interest and a cascade of comments. They ranged from the acute and perceptive to the callow and credulous – but all were seriously intended and deserve broader exposure and responses.

So picking a sample of some half dozen, and inviting the discussion to continue: 

PF noted to Francine that “the idea has been floated of having each exchange traded company purchase insurance against the financial impact of future restatements or fraud, but for that to work you would merely replace the auditors with the insurance industry, who would need to do their own “audits” before they would agree to underwrite such large risks.”

And David wrote similarly, that, “maybe each firm performing audits should have to put up a bond that would be available to creditors in the event of malpractice lawsuits. Let’s say that bond was equal to at least two years of the firm’s audit revenues. … You could even have an experience rate type of adjustment….”

Sorry – we've been there. If feasible, the idea of outside sureties would already be in place by now (here). The marketplace reality is that the insurance industry – which suffered massive losses on its coverage of the accountants during the savings & loan debacle of the 1980’s – learned enough to avoid a repetition.

It’s not just that the Big Four tetrapoly fail the essential tests of insurability, although they do – because of sector concentration, unpredictability of losses and inability to quantify exposures. It’s also that if any such “super-audits” actually existed, the auditors would surely be performing them already. The sad fact, instead, is that the poor profession is operating today to the best of its unfortunately limited capability.

On user expectations, Robert accurately observed that, “an audit is supposed to provide reasonable assurance, not absolute. An audit firm has many engagement teams…some good…some bad. The whole system can’t be vilified because of isolated events.”

“Vilified” – perhaps not. But it is precisely the isolated events – highly-consequential and destructive as they can be – that will bring down another large firm.

On this there are two points: First, because the accounting profession lacks an effective forum by which to scrutinize and learn from its failures and short-comings, it has been unable to avoid repeating the same performance deficiencies from one generation to the next. It's a failure in historical perspective, to miss the instructive comparisons between Parmalat, say, and Equity Funding – or between Satyam and ZZZBest.

Second, the community of financial statement users is unimpressed by the profession’s proclamations of its successes. Virtue is not preserved by an accumulated preponderance of generally good behavior – rather, it is dissipated and lost altogether by individually corrosive, culpable acts. For most of their life spans, John Edwards and Tiger Woods were credibly decent – as were Jimmy Cayne and Dick Fuld and even Conrad Black and Bernie Ebbers -- except for certain nasty instances when they were not.   

I had this note from JD: “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.”

The problem is the last sentence. Under the large firms' presently dysfunctional model of litigation exposure, independence constraints, limited capital and concentration of resources and expertise, it is just not the case that alternative providers might emerge to replace a failed Big Four firm. That discussion can be expanded at greater length, and has been, but the only answer is "no way."

Francine had this interesting proposition from TT:  “the first firm to focus on quality, and to deploy and consistently follow standards that enforce quality regardless of other factors and metrics, will rise above the others. … But the sad fact is right now that the clients don’t perceive any differences between the firms, and it would take a significant difference to catch the clients’ attention.”

The standard audit report now being an undifferentiated commodity, TT’s point was answered by Geoff, who wrote that, “From 1933 until now, there hasn’t really been a evaluation of the core assumptions around audited financials. The requirements have evolved and become more detailed, stringent, as we go through the motions of continually fighting the last war. Add to it the institutionalization of the main players (audit firms, regulators, accounting designation self-regulatory bodies), and it’s easy to see how we’ve lost the plot.”

To conclude, the widespread inchoate desire for “something better” resounds in Esa’s plaintive note:

If you know of a better model that allows us to hold someone responsible for unforeseen future events, I’m all ears but that’s not a job I want.

A lot of people think the model is relevant though it certainly has flaws. The SEC, institutional investors, financial analysts, etc. all think the model requires tweaking but none suggest wholesale changes.

If fact, I haven’t heard anyone propose something that even comes close to a reasonable alternative that is actually feasible. If you have ideas on that front, please share them.

That’s an echo of the call from Francine and me. Progress will come neither from the self-interested parties' reticence to “suggest wholesale changes,” nor their continued pointing of fingers and weapons. Instead, as a first step at least, let the wide-open conversation continue.

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Disintegration of the Big Four -- Where is the Tipping Point Today?

Time for an update: how large is the litigation hit that would devastate one of the Big Four accounting firms?

The answer is a number that is shockingly small, in light of the large firms’ aggregate estimated litigation exposure of up to $140 billion and their individual confrontation of multiple claims ranging up to and well above $10 billion.

But it cannot be avoided. Reckonings are coming, when the debate on the survivability of privately provided audit services is revived – which will be some time after the U.S. elections and the dust-settling around the world’s banking bail-outs.

Quantification of the impact that would trigger the disintegration of the global networks -- leaving the world’s large companies unable to procure the audit reports necessary for listing and regulatory compliance – was a subject last visited two years ago.

A study done in September 2006 for European Union markets commissioner Charlie McCreevy (here) did that calculation for the large U.K. firms. I applied its model to the Big Four’s American firms that December (re-published here) – and attracted no substantive disagreement, but instead grudging if off-the-record concurrence from those positioned to know.

A revision is now possible, and the news is no less grave.

The recent report of the U.S. Treasury’s Advisory Committee on the Audit Profession (here), for all its insipid unwillingness either to acknowledge the gravity of the audit survival risk or to propose an achievable course of action toward real solutions, did provide updated financial data from the large firms.

Those figures can be run through the prior model, after a quick recap of its basic assumptions: 

•    Not having access to outside investors, under regulatory limitations, and impelled by tax laws to distribute their profits, the accounting firms operate on the thin but vital base of their partners’ personally invested capital.

•    The insurance industry’s readiness to contribute to the firms’ litigation outcomes is insignificant compared to the size of pending claims; comes – if at all – only on top of large and growing deductions and retentions; and in any event takes primarily the form of time-shifting finance.

•    As a result, large litigation settlements must be funded out of future partner profits, which depend on the ability of the firms to retain both clients and personnel.

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.

Based on the profits calculable on the Big Four firm’s U.S. revenues of between $5.3 and $9.8 billion, as provided to the Treasury Committee, the bust-up figures would be as small as $560 million, up to just over $2 billion. (Those wanting a walk through the model are invited to write me.)

Could such death-blow amounts be inflicted? On top of the firms’ recent hefty payments to settle many (but not all) of the wave of post-Enron litigations, the outstanding jury verdict of $521 million against the Seidman firm in Florida (see here) starkly demonstrates the possibility. And the obligation of plaintiffs’ lawyers to represent their clients’ antagonistic interests weighs against any lingering unwillingness they would have to kill the gaggle of golden geese.

Would the Big Four firms’ international networks step up? Although by all measures the most cohesive and financially robust of the firms, Arthur Andersen collapsed in 2002 with a speed that suggests otherwise: that firm’s ability to call on either foreign resources or partner commitment proved ephemeral.

Keep in mind that loss of another Big Four firm will throw the entire system into chaos – for lack of auditor choice and readiness among the survivors to stay in an untenable business. So the stability of the entire fragile structure includes the continuing survival of the weakest of them. 

That in turn exposes the hopeless state of the public debate. When corporate bankruptcies have shot far beyond the $100 billion mark, it’s a dead certainty that investor advocates can kill at birth any proposal to limit auditor liability at a level low enough to include the tipping points.

Nothing less is required, then, to enable the survival of large-company audits under the current model, than a de-coupling of the machinery of investor protection and auditor oversight and enforcement from the Big Four firms’ fragile capital structures.

Until that point is recognized and on the table – even if not agreed—the debate goes nowhere. While the risk of catastrophic failure only grows.

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Audit Firm Survival -- Is Government-Backed Insurance at the Cutting Edge?

Considering the vacuity of the debate on the survivability of the Big Four audit firms and the delivery of audits to large public companies, especially at official levels – see here – there should be full exploration of all ideas that at least pass a laugh test.

So I was tantalized by Tom Selling’s suggestion last month (The Accounting Onion) to reincarnate a “Big Eight”, if “the government could offer to share the litigation exposure from each of the Big Four’s prior audit engagements in exchange for [their] splitting up into two completely separate firms.”

Well, maybe. But anyone thinking that large-company audits would be helped by hacking up the large firms should consider this tool: the razor named for 14th century English friar and logician, William of Occam, whose rule of succinctness states that all things being equal, the simplest solution is the best.

Beyond the purely political issue that auditor liability reform is an officially toxic topic in Washington, and the absence of any legal foundation for such slicing and dicing, there are some practical issues:

First, unless the Big Four bifurcate their industry teams, no new competition would emerge. That is, if a current Big Four health care or insurance practice spun off as a whole into one new firm, while its technology or energy practice stayed intact but went to another, the range of auditor choice within an industry would not be expanded.

And the glacial and ineffective pace of change within the profession itself makes it unlikely that senior experienced audit personnel would have the incentive or take the initiative to re-tool their expertise from one industry over to another.

On the other hand, however the Big Four firms might be broken up, it would not reduce the complexity or resources needed to audit a large global company. For example, each half of a firm’s split-up banking industry practice would still require a full-bore set of technical and regulatory expertise. With the loss of economies of scale, duplicating such competence would reduce efficiency and increase rather than reduce the cost of large-client engagements.

Relatedly, on the issue of performance quality, Selling suggests that the Big Four may have grown “too decentralized to control.” But to serve global companies, Big Four practices riven in two would still need a serious presence in all the countries where their clients require service. That challenge of scope, scale and resources is not solved today by the Big Four’s smaller brethren – and would present an immediate quality challenge to any Big Four offspring.

Which asks the question whether division would be desirable beyond the US, in countries deemed to be low risk. Are there any candidates? Significant litigation now originates in engagements or companies as far-flung as Italy, the Netherlands, Russia and South Korea. So countries attractive for firm mitosis may be few indeed. And with one or two of the Big Four typically dominant in the larger non-Anglo countries, division of the firms only in the US might well have perverse effects on concentration elsewhere.

As for the economics of a bail-out, leave aside the political improbability that government would assume a litigation exposure currently estimated to exceed $100 billion. True, the cost of a rescue would be chump change compared with the taxpayer burden looming over the impending rescues of Fannie Mae and Freddie Mac – but public passions are far less aroused for auditor salvation than for the country’s dominant home mortgage institutions.

The idea is a non-starter for other reasons, starting with the impracticality of doing a “one-off.” That’s because protecting the Big Four from today’s catastrophic litigation threats does nothing for the future. Any new mini-firm would, post-split, still be exposed to the next generation of cases that – based on four decades of experience – will inevitably arise.

And it would not bode well that smaller, capital-challenged new firms would have only half the financial resources they do now, when they are already facing litigation-driven extinction.

There is one positive glimmer in the heart of Selling’s idea – a stand-alone government assumption of the large firms’ catastrophic exposures.

Today the Big Four are forced to settle their biggest cases. They lack either insurance or partners’ capital robust enough to take the non-trivial risk of going to trial and incurring a punishing adverse outcome.

It cannot be imagined that politicians would create a $100 billion honey pot for the investor plaintiffs and their lawyers to dive into. But there could indeed be created a federally underwritten catastrophic re-insurance mechanism or “litigation trust” – which as a form of contingency capital would enable the firms to litigate their cases without fear of a death-blow verdict.

If such a lifeline were available, it would obviate the viability threat. So simplified, the very reasons for the otherwise impractical Big Four split-up go away. The firms in their current form could then address their twin goals of quality and relevance, without the distractions of imminent overhanging bankruptcy proceedings.

Using Occam’s Razor to pare away the parts that fail to benefit audit delivery effectiveness, the Selling proposal suggests a financial buffer worthy of consideration.  That idea would logically be housed in the proposal I outlined on June 10 – here -- for a government-sponsored structure of charters for firms doing audits of publicly-traded companies.

So let the discussion continue.

Catastrophe Bonds for Auditors -- An Idea that Refuses to Stay Dead

Our teen-ager just finished a great school course, “Monsters In Literature.” The class read about all manner of scary creatures, the most gruesome being those who, once roused, were hardest to kill off.

In the antagonistic drama about the impact on the global capital markets of the impending collapse of the large-company audit function, the role of doctor Frankenstein goes to George Washington University law professor Lawrence Cunningham.

Cunningham has proposed an alternative to liability caps – here.

With the large firms showing no sign of the communication and strategic skills needed in the unfriendly American political and regulatory environment, Cunningham suggests instead that they issue high-interest “catastrophe bonds” – whose principal would be callable to cover massive litigation awards. His analogy is to the now-familiar “cat bonds,” that fund against damages from hurricanes, floods and other natural disasters.

Developing events have driven stakes through the hearts of other unworkable salvage proposals: Mandatory auditor rotation was only ever tried in Italy, where the collapse of Parmalat put an end to the export of that idea. The prospect of global scale competitors for the Big Four has been quashed by the Bankest verdict against BDO’s Seidman firm in Miami and the pending one-two against Grants of Parmalat and Refco.

Not that it’s wrong for Cunningham to be skeptical of the large firms’ case for liability caps, as they continue to resist calls for financial transparency. But he misses the broader public policy issue. The non-trivial likelihood of a disruptive “worst case scenario” is broader than the cost to its partners of the next firm’s failure – it’s about the reverberations in the capital markets caused by the cascading failure of the entire franchise. 

Trouble is, the weaknesses in the firms’ messages do not make viable the alternatives. Although the critique of Cunningham’s proposal by insurance expert Kevin LaCroix – here -- should have laid its ghost almost two years ago, it still stirs. So a brief comparison on the basics of insurability is in order:

Diversity: The essence of real insurance is the spreading of risks – whether life insurance for a broad population or hurricane bonds across the broad geography of the Caribbean. No life underwriter would survive that served only insureds from a single hospital ward of the terminally ill. Just so, the concentrated and homogeneous Big Four audit market is exposed to every major financial collapse anywhere in the world.  

Predictability: Dangerous as it is, the annual hurricane season is measurably limited by the calendar. And exposed as is its geographic region, there are no hurricanes in Paris or Chicago. Effective modeling gives a confidence level in the expected volume and severity of claims.

By contrast, the Big Four’s risks extend across every one of their clients large enough to generate a billion-dollar claim. And the presence of globally-recognized names in their litigation inventory illustrates the pervasive nature of their exposures. Models of frequency and severity are simply ineffective to measure and set prices for the extremes of unpredictable events arising out of human malfeasance.

Independence of Cause and Impact: Mother Nature does not generate hurricanes in order to trigger claims against available insurance or cat bonds. The flood takes out the bridge, whether it is insured or not. But Cunningham goes astray in his assertion that auditor cat bonds would not “attract suits against auditors because they fund only catastrophic losses, upwards of $500 million.”

Large sums not incentives to the plaintiffs’ bar? Did anyone ask them whether money talks or not! American class action lawyers have never shied from auditor liability cases on a multi-billion dollar scale, and the existence of a ten-figure honey pot would be well publicized and irresistible – both commercially and as a matter of the lawyers’ ethical obligation to provide zealous advocacy to their clients.

Still, the most telling evidence that auditor cat bonds have no pulse is that in recent years the smart guys in financial services, who had left no source of securitization unexplored, have taken a pass.

Put another way, if the idea were viable, the bankers and insurers would have been there by now. The combination of greed and ingenuity that transformed portfolios of subprime mortgages and other doubtful debt into the multi-layered mountains of toxic financial waste spread across the capital markets was readily transferable. To extend that creative venality to the cobbling up of an auditor cat bond needed only to breathe the life of profits into the body on the laboratory table. And it hasn’t happened. 

It is of passing interest that in Bram Stoker’s 1897 original, the eponymous Count Dracula was actually able to live and move about in the daylight. But as US Supreme Court Justice Oliver Wendell Holmes put it in a more elegant context, “sunshine is the best disinfectant.” So illuminated, the idea of catastrophe bonds for auditors deserves its place, tightly closed up in a box with the lid nailed shut.

Catastrophe for the Audit Firms ... and the Talk Goes On, and On, and On ....

Did anyone really think that the endless chatter about saving the system of privately-provided audits for large global companies would come to anything?

If so, that fantasy was dispelled on June 3, in the closing minutes of the latest meeting of the U.S. Treasury’s Advisory Committee on the Auditing Profession – webcast here. In his summation, Co-Chairman Don Nicholaisen explicitly stated that, with an insubstantial exception, the Committee’s recommendations “do not address catastrophic risk” of the loss of the Big Four.

Why not? The Committee’s very mission is to “examine the sustainability of a strong and vibrant auditing profession” – here.

But if its members cannot face the potential for catastrophic failure of the Big Four, the Committee is serving no purpose. None of its other minutely examined but anodyne topics of inquiry – such as tweaking the standard for fraud detection or probing yet again the criteria for an accounting degree – will have any effect when another Big Four firm’s collapse takes down the entire business model.

Those durable enough for the entire webcast observed that the civility level of the dialog was frayed and degrading, even while the members spent the day largely talking past each other:

•    Testimony from the Big Four and the insurance industry provided the count of death-threat litigations: 27 cases with damage exposures above $1 billion, of which 7 exceeded $10 billion – with the estimated total between $100 and $140 billion. The large firms cling to their tactically sound but politically tone-deaf refusal to offer comprehensive data on their own financial condition, but the litigation potential to overwhelm their partners’ limited capital is unrebutted.

•    A committee member with a union background took the position that loss of another large accounting firm was an acceptable risk, asserting a risk comparison between an audit partner and a coal miner or a police officer. What he omitted was that while no single actor could threaten the entirety of the coal industry or the justice system, one more blown audit on the scale of an Enron or a WorldCom could end the deliverability of audits as known for 160 years.

•    Former SEC chief accountant and persistent critic of the profession, Lynn Turner, showed his hostility to the option of liability protection with the ring of a jury argument: “Do you believe that an auditor found to have been aware of financial reporting problems but never reporting them to the public should be the subject of liability caps or some type of litigation reform protecting them?” Yet Turner’s position that “this is about regulating a federally mandated and authorized cartel,” involving a “too big to fail” condition where market forces no longer work, is perilously close to a concession of how bleak the future is.

•    Committee member Gary Previts, historian of the profession and professor of accounting at Case Western University, put it in an academic’s genteel way: “I have often wondered if we aren’t trying to fix a business model … that is not subject to being fixed … if you started with a blank sheet of paper, whether we’d be organized the way we are today?”

The position that the Big Four must be left exposed to risks so dire that they could fail, clashes with the large firms’ showing of their inability to staunch the outflow of their limited resources in settlements of cases too large and dangerous to take to trial.

Further – so far as the availability of large company audits assumes the viability of the large audit firms themselves -- it is in conflict with the simultaneous view that the assurance function is so vital to investor interests that it must be preserved. Yet that is the very theme sounded in October 2007 by Treasury Secretary Hank Paulson in launching the Committee – that “a vibrant auditing profession is essential for a well-functioning financial reporting system (here).”   

So what is needed is a different cliché.

It’s not that the Big Four are “too big to fail.” Life is no safer for the survivors since the 2002 demise of the Andersen firm. They can fail. And the Committee’s co-chairman has now admitted that nothing is on the table to save them.

Rather, despite the lip service paid to the importance of audits to the capital markets, the regulators and politicians are themselves “too weak to stop failure.”

Put another way, those sincerely believing in the importance of large-company assurance are avoiding an election between two unappealing choices: Either put every effort to assure that the Big Four are insulated from the very catastrophic risks that the critics insist they must remain exposed to, or start the process of designing the new audit model that must arise after the collapse of the Big Four under the abdication of the Treasury Committee and its counterparts.

In the loud clanging of the Committee’s cognitive dissonance is the tolling of its usefulness. Chairman Nicholaisen’s concession of futility in the face of catastrophic risk says as much.

So the most the Committee can do is declare its one achievement – the comprehensive laying out of mutually-defeating antagonistic positions – and spare further contribution to the global level of greenhouse gasses.

The Future of Auditors as Gate-Keepers -- A Glossary of The Non-Solutions

Do investors get real value from their gate-keepers? It was a main question at a conference of international investment managers where I spoke last week.

This group -- who sit over funds across the spectrum from public employee and union pensions to hedge funds and private equity – had common concerns: corporate governance, ethics, compensation and performance, and the quality and reliability of the third-parties – the analysts, rating agencies and outside auditors.

On the subject of the auditors, I had a brief opportunity to offer this three-fold view – familiar enough to regular readers here, but beyond orthodoxy to many in the audience (and with thanks to Mark Cobley at Financial News Online for the uptake):

•    That the traditional form of auditor’s report is obsolete and provides no investor value, especially compared to the possible forms of assurance that are impossible under the current model -- here;

•    That the overwhelming pressures on the Big Four firms render their current business model unsustainable, and their litigation-based exposure makes disintegration inevitable, absent a radical and comprehensive re-engineering – here;

•    That the current dialog on achievable solutions is vapid and sterile, due to denial, blame-shifting and the limited vision of all of the interested constituencies -- here and here.

In the ensuing barrage of panelists’ skepticism, audience questions and post-session follow-up, I was challenged to answer in single sentences to all the standard one-dimensional “solutions” to the fragility of the current Big Four structure.

Bringing those exchanges together here, with links to their more extensive treatment elsewhere, seems worthwhile – even if only in sound-bite form: 

•    Q: Why isn’t the litigation threat to the Big Four well handled by insurance?

A: Having learned from the savings & loans in the 1980’s the expensive lesson that auditor liability fails the basic criteria for insurability – diversification, predictability and quantification – the insurance industry has voted with its feet -- here.  

•    Q: If lack of auditor choice is the issue, how about creating competitors by splitting up the Big Four?

A: For starters there’s no workable legal theory. Either industry and geographic expertise would stay concentrated, in which case nothing is achieved, or they would be so split up that today’s talent level would be severely diluted.

•    Q: Can’t the issue of Big Four concentration be solved by built-up competition from the smaller firms?

A: The size gap is just too large to bridge – see here – and the smaller firms are if anything even more at litigation risk – see here. Anyway, smart risk managers in those firms would avoid global-scale engagements for which they lack either the skills or the risk appetite.

•    Q: If the rules on audit firm ownership were relaxed, wouldn’t outside capital both strengthen the Big Four firms and support new competitors?

A: The Big Four don’t want or need extra capital to run as they do – here. And the bankers have shown they are smart enough not to sacrifice new money that would only fuel the litigation fires.

•    Q: How about improving audit quality by requiring the rotation of auditors?

A: Italy being the only large country to mandate changes in auditors, experience provides a one-word rebuttal: “Parmalat.”

•    Q: Doesn’t a system of joint or dual audit promote higher quality of performance?

A: Proponents in France, which has almost no history of auditor liability litigation, would quickly change their tune when joint auditors became subject to 100% joint and several liability in the courts of other countries.

•    Q: Isn’t the problem of impaired audit independence the fact that it’s the clients who pay the bills?

A: Consider the alternative: funding audits through an agency or regulator amounts to nationalization – and no one makes the case for audits by government civil servants. 

•    Q: How about caps on litigation liability – either money limits or percentage allocation of fault?

A: Because the size of claims arising out of large corporate failures so completely dwarfs the limited financial capability of the Big Four – here – the political process cannot set a survival bar so low as to ensure the stability of a large firm under serious litigation threat.  

•    Q: Wouldn’t performance standards based on principles rather than rules recognize the judgmental nature of auditing?

A: Standard-setters cannot reduce the liability threat, so long as it is courts and juries who assess auditor fault and liability, unless there is the readiness – so far unseen – to enact “safe harbors” to protect the auditors’ judgments.  

•    Q: If another Big Four firm were failing, couldn’t regulators waive the scope of service limitations so that another firm could step in?

A: Even if the large firms weren’t so ostracized already that this solution is politically untenable, they are already fully-stretched and without resource capacity, so that when another firm crashes, the three survivors could not possibly pick up the pieces out of the wreckage. 

•    Q: If another firm is threatened with disintegration, how about replacing its tainted management with a credible outsider?

Q: As shown by the failure of Arthur Andersen despite Paul Volcker’s well-meaning initiative, the speed and complexity of a disintegration would out-strip any outsider’s powers or resources – see here.   

•    Q: In the end, won’t the regulators act to prevent the collapse of another global audit firm?

A: There is no more candid response than the concession of William McDonough as he neared the end of his term as chairman of the Public Company Accounting Oversight Board: as to what the regulators would do about another disintegration threat, “they don’t have a clue.”

These are sound-bites only, as I said, and I may have missed a point or two. Either way this compilation should be a good reference point. Please don’t hesitate to write with your reactions and suggestions.

Insurance to Save the Auditors -- Yet Another Non-Starter

This column was originally published in the IHT on August 27, 2005. With other related work in the pipeline, I pick it up now mainly for archival reference, although -- with apologies for the anachronisms --  it remains just as current today as it was then.

Plot Twist Hits Reality

This has been a good summer for melodrama. First, there was Steven Spielberg's film "War of the Worlds," with its specter of alien invaders. Then there was "Attack of the Giant Liabilities," with the mega-settlements paid by banks in the Enron case - and the prospect of more to come in the cases of Parmalat, AIG and others.

The movie's hero was Tom Cruise. No similar savior exists for the Big Four accounting firms, beset by performance worries, liability overhang and structural threats to the viability of their core product, the standard audit.

But as part of a healthy debate over the future of the profession, a proposal was floated in July by a fellow columnist, Joseph Nocera of The New York Times -- here: Corporations would buy an optional "audit insurance," which their insurance companies would issue after a new and separate form of audit examination. This new coverage would, in theory, protect shareholders from losses resulting from faulty auditing.

An entertaining idea. But is it realistic? A few questions to explore:

Are there accounting firms available to do this new work?

The U.S. Securities and Exchange Commission and other regulators are not willingly going to surrender their requirements for standard audit reports, so companies would have to find a second accounting firm with the skills and resources to perform the new audit. That, by definition, means another member of the Big Four: PricewaterhouseCoopers, Ernst & Young, Deloitte & Touche and KPMG.

The problem is that most Big Four clients - after eliminating their current auditor and any firms of which they are consulting clients - will find there is at best only one other firm eligible to bid for new work. This was shown last autumn when Fannie Mae had nowhere to go but Deloitte after firing KPMG. The choice, already poor, threatens to become irreducible.

What about personnel?

The Big Four firms are already operating flat out, to the point of staff abuse, under the burden of work required by Section 404 of the Sarbanes-Oxley Law, and they are hiring workers as best they can to replace those they chew up. It is not a recipe for success to think that they could ramp up further, to perform a new, high-value service with workers hired from the next lower level of education and professional competence.

If the current audit firms took on a new role, what additional work would they do?

Auditors today already put their reputations and their survival on the line by issuing opinions that financial statements are free of material error. There simply is no more or different work they are competent to do - either to bolster that opinion, to manage their overhanging catastrophic litigation exposure, or to entice the insurance companies. Because if there were, they would be doing it.

Would the numbers work out?

As Nocera recognized, the problem is one of scale. Audit insurance would never cover an Enron-like debacle - namely, investor losses from a $67 billion bankruptcy. But in positing that the new coverage would be more than enough for shareholder losses from bad audit news, he misses two key points.

First, in the U.S. legal system the auditor can now be held liable for 100 percent of all investor losses, even in a large-scale debacle like Enron. Second, whether or not a shareholder suit ever comes to trial, the escalating size of the pretrial settlements - like those of the banks in Enron and WorldCom - threatens to eat up the accounting firms' total capital.

In other words, an incremental addition of small-scale insurance is a proposed solution for the wrong problem. It's the mega-cases, the ones threatening to kill the Big Four, that are running amok through the current legal system and its puny arsenal of defenses.

Would the insurers want to play?

The popular perception is that insurance capital is a rainbow pot of infinite size. The truth is that the role of insurance as a risk-spreading intermediary is constrained by competing demands on its limited capacity. The insurers, burned by a generation of bad experience, have already looked at the auditors' exposure and are devoting their resources to more predictably quantifiable disasters - like hurricanes and airplane crashes.

Audits of real value to investors can be done - but only with realistic and achievable standards, at higher cost, and with tolerable liability limits. The chances of getting there, with the engagement of all the necessary players, may be as unlikely as an invasion of aliens. The process has just begun.

The Accountancy Regulators -- Motion Is Not Progress

My last post, critical of the proposal from the SEC’s Committee on Improvements to Financial Reporting for a “judgment framework” for accounting and audit decision-making, generalizes across the lack of substantive debate on the difficult state of financial reporting and the auditors’ threatened assurance franchise.

More public meetings are on the calendar – specifically, the US Treasury’s Advisory Committee on the Auditing Profession meets on March 13 (here), the CiFIR itself meets the next day (here), and the US Chamber of Commerce's Center for Capital Markets Competitiveness holds its next annual summit on March 26 (here). The hot-air potential is high -- the optimism level is not. A catalog of inter-related issues remain completely unresolved, without any visible progress against an agenda laid out in this still-relevant column that ran in the IHT on April 22, 2006:   

Solutions That Are Not

There's no finding solutions without a proper focus on the problems. Think of the guy in the dark of night, searching under the street lamp for his keys. The beat cop asks, "If you say they were lost over in that dark alley, why are you looking here?"

"Because the light's better here," the poor guy responds.

Which pretty much describes the January, 2006 report of the U.S. Chamber of Commerce, joining the dialog on the survivability of the large accounting firms under the stunningly obvious title, "Auditing: A Profession At Risk" -- here.

With its heart in quite the right place, the group says "action must be taken" so that companies might retain "access to high-quality, reasonably priced auditing services."

Whereupon, sadly, the report loses its focus and its way, bumping dimly down the dark streets from one missed opportunity to another.

Here are six of them:

First, the chamber gamely recognizes that the audit profession has become effectively uninsurable in the face of litigation costs that threaten immediate destruction of partners' limited capital and their long-term inability to hire and retain personnel.

Yet its limp observation that legal reform "may be needed" misses the crucial point. Auditor insurability requires the ability to predict, quantify and limit the insured risk - conditions impossible to fulfill under unlimited liability hazards.

Second, the chamber repeats the familiar if unhelpful refrain that auditors should not be held liable for failure to detect or prevent cleverly designed collusive fraud.

That's fine, as far as it goes. But what about the many corporate frauds that aren't that clever or well concealed, but that repeat shenanigans perpetrated for generations? And what about all the "fraud" that consists of aggressive use of permissive accounting standards set under the influence of corporate interests themselves?

Also, what about auditors who, faced with a crushing liability overhang, are forced to settle their mega-cases without going to trial?

Third, the chamber proposes that the Public Company Accounting Oversight Board, the U.S. industry regulator, should promulgate a "safe harbor" standard for fraud detection, to protect the auditors if they can show they fulfilled steps issued by a bureaucracy.

Yet it is this very "check the box" approach to the control assurance requirements that is the Achilles heel of the Sarbanes-Oxley law. Companies whose stock trades on U.S. exchanges, and therefore must register with the U.S. Securities and Exchange Commission, are furious at the escalated cost and diminished effectiveness of auditor performance because of the Sarbanes-Oxley requirements - to the point of avoiding or fleeing U.S. listings altogether if they can.

Fourth, the chamber serves its own broad constituency of small businesses by suggesting that the audit profession's doubtful viability is not helpful to new companies that may be innovative but unfamiliar to the capital markets.

Trouble is, that's not where the real threats lie. It's not the unknowns with the biggest and most costly claims in this decade, but household names: Enron, WorldCom, Adelphia, Xerox and Parmalat.

Fifth, understandably exercised over the mortal blow of the indictment of Arthur Andersen over its work for Enron, the chamber calls for legislation to "rein in" the process of indicting whole enterprises.

Here the problem is that unless world trade and commerce unexpectedly achieve an as-yet unknown state of grace, society will expect its law enforcement officers to indict and prosecute where indicated by the facts.

Sixth, the chamber joins a chorus of concern over the shrinkage down to the Big Four, who together audit virtually all of the world's largest companies. But the relocation to smaller firms of non-audit work is once again off point: Those are not statutory compliance services, where the real legal risks and fatal exposures lie.

To be fair, though, the chamber may be so turned around because it started from a faulty bearing - that auditing is central to public confidence in the capital markets. When the next big auditor disintegrates amid litigation, it will become obvious that the delivery of services by a noble profession in the process of collapse will not be something anyone will be able to preserve.

In the small pool of light cast in this darkness, that much is right out in plain sight.