Re:Balance -- Jim Peterson

My New Book -- "DOA: Can Big Audit Survive the UK Regulators?"

It is a pleasure to announce the availability of my new book -- "DOA: Can Big Audit Survive the UK Regulators?" -- now available in paperback and e-reader versions through Amazon -- here. 

To summarize the story, which is little enough comprehended even in the United Kingdom, and both seriously under-reported and much misunderstood in the United States and elsewhere:

"The collapse of Arthur Andersen in 2002 reduced the large accounting networks to the Big Four – Deloitte, EY, KPMG and PwC. Can they survive, in a model fit for purpose?

 "Public criticism and the hostility of regulators and politicians are intense, especially in the United Kingdom since the January 2018 collapse of contracting giant Carillion. The debate is joined, the outcome is uncertain, and the consequences to the capital markets will be profoundly disturbing.

"The issues are complex: audit quality, the 'expectations gap,' competition and choice. Disruptive 'solutions' include breaking up the Big Four, stripping their people and services back to 'audit only,' and even nationalizing audit assignments. 

"DOA surveys the background to the current UK environment, examines the possible actions, and assesses the doubtful prospects for beneficial change." 

By its focus, in the current volatile British environment, on the political, regulatory and litigation risks that swirl globally around the Big Four, DOA is a sequel to the detailed scrutiny of these issues in my earlier and still-relevant book, "Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms" (Emerald Books, 1st ed. 2015, revised and extended paperback edition 2017 -- also on Amazon).  

The certainty of global implications for the continuing availability of assurance on the financial information of the world's large public companies, including the stability and viability of the Big Four themselves, makes broadly relevant the actions and decisions of the regulators and politicians in the UK. 

I invite your attention to the examination in DOA of these important issues. Please share with friends and colleagues. Comments here via the Main page, and reactions and suggestions to me at [email protected], are invited and most welcome.

 

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]

Standard & Poor's in the Gunsights: High Noon at the Triple-A Corral

The United States Justice Department filed a five billion dollar lawsuit on February 3 against credit-ratings agency Standard & Poor’s, over its ratings of mortgage-backed collateralized debt obligations lying at the heart of the last decade’s financial crisis (see here and here). 

Settlement talks had broken down, over S&P’s reluctance to admit to fraud charges. But the wager here is not the over/under on S&P’s eventual and inevitable settlement. Before that, there will be much posturing and a long way to run.

For sure, McGraw-Hill subsidiary S&P has lawyered up for the battle, adding to its team the trial capability of über-barrister John Keker – advocate for such luminaries of civic virtue as Enron’s Andy Fastow, Credit Suisse’s Frank Quattrone, Lance Armstrong, Eldridge Cleaver and de-frocked king of the securities class action bar Bill Lerach. 

Of concern, rather, is the longer-term impact on the roles, relationships and exposures of the various gate-keepers, ambiguously deemed critical by society to the global capital markets.

The New York Times’s Floyd Norris scratched the surface of this issue – here – but beneath lies much more.

Consider this menu of common attributes:

• A standard, commoditized report, without which financial products cannot be brought to the investor market.

• Providers not engaged by or in direct contact with investors, but competing to be engaged and paid directly by the issuers.

• Despite which, elaborate assertions of “independence” – widely criticized as resting on the intellectually shaky platform of “appearance.”

• Severely constrained choice among providers to large issuers, from a number of players limited to the low single-digits.

• Barriers to new competitive entry based on market demands for global scale, competence and resources – although tightly regulated, the provider cartel is not constrained by limits on government licenses or other franchise restrictions.

• Claims that, broadly speaking, the reports reasonably reflect reality, most of the time – except under highly stressed conditions, when they do not – a position not unlike the claim that the Boeing 787’s lithium-ion batteries work reasonably well, most of the time -- except when they catch fire.

• Provider claims to have adjusted and improved methodologies and process in light of recent criticisms – proclamations echoing those of my college era, before political correctness, that “Vassar girls don’t do those things -- and besides, the grass was wet.”

• Finally, the standard document noted at the head of this list, explicitly couched in the language of an “opinion” – as if, despite the construction of an elaborate and expensive pyramid of supportive analysis and procedures, the result were intended as a Zagats review or a “like” on Facebook.

Up to the last, this list of attributes would apply equally to the three dominant ratings agencies – S&P, Moody’s and Fitch – as to the accounting tetrapoly of Deloitte, E&Y, KPMG and PwC.

Except for the dissonance at the expectations gap, where the global accounting networks face existential litigation exposure for each large-company audit report they sign, while the ratings agencies have – until now – successfully wrapped themselves in the armored blanket of the First Amendment.

Does the government’s suit against S&P portend a realignment of the exposure realities? S&P’s free-speech advocate Floyd Abrams has forsworn a First Amendment defense (here), so a new era of litigation risk may confront S&P as well as its brethren.

From the audit firms’ perspective, though, any temptation to schadenfreude is hazardous – because of the speed and vigor with which the slightly guilty pleasure taken at another’s misfortune can turn to ashes.

Especially if there should be a contagion effect.

 

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Ratings Agency Liability -- The Aussies Turn the World Upside Down

The litigation exposure of the Big Four accounting firms has not been made easier. 

The global networks should take no satisfaction from the field-leveling decision of Judge Jayne Jagot of the Federal Court of Australia, who on November 5 found ratings agency Standard & Poor’s (S&P) negligently liable to the purchasers of “grotesquely complicated” derivatives, designed and sold by ABN Amro. 

Schadenfreude would be wrong – and not just because it’s too hard to spell.

Consider the cries for accountability, during the recent years of financial calamity, by the auditors and the ratings agencies (e.g., here and here) – both of them, depending on one’s perspective, either vital gate-keepers to the markets, or aiders and abettors of the malefactors.

When their roles are compared, the guilty shiver of pleasure at another’s troubles would under-estimate the potential spreading of exposure. Consider the similarities: 

• Both have come to be viewed as essential functions in the world’s capital raising – chiefly by their regulatory authorities, to whom self-preservation and continuing existence are their own primary raison d’être.   

• Both are engaged and paid by their clients, upon which direct financial relationship they construct an elaborate edifice in illusory support of the intellectually unsatisfactory concept of an “appearance of independence.”

• Both seek to advance credible arguments that there is legitimate competition in their sector, despite effective barriers to entry that maintain their pass-the-parcel hegemony and an ever-tightening dominance by their respective global cartels.

• Their core products – the standard audit report and the three-letter rating – are delivered to users in prescribed and commoditized language – of which the source is a matter of consumer indifference and authorship would not be obvious absent a letterhead. 

• And finally, both couch their language in the qualified language of “opinions” and “judgment. ”

As to the last, however, the critical survivability difference emerges.

Namely, while S&P and its brethren have succeeded in wrapping themselves in the fuzzy if heretofore liability-proof blanket of the First Amendment’s free-speech protection, the auditors have long skirted disaster at the hands of a hindsight jurisprudence that threatens damages far beyond the limits of their financial tolerance or capacity. 

For the detail geeks, ABN Amro’s eye-crossingly complex derivatives, code-named “Rembrandt,” and the model-gaming involved in the rating process are laid out in overwhelming detail in the summary of Judge Jagot’s massive decision, and are thoroughly and colorfully discussed elsewhere – here and here.

The result threatens to turn topsy-turvy the ratings agencies’ comfortably protected world. Her Antipodean perspective is that S&P’s triple-A ratings were “misleading and deceptive,” involved “publication of information or statements false in material particulars,” and could not have been given by “a reasonably competent ratings agency.

For the ratings agencies themselves, the threat of worldwide contagion after the Rembrandt decision may be mitigated by both the availability of continuing scorched-earth defense strategies and the likely expiration of statutes of limitations to shield them from crisis-era claims.

For the auditors, who as noted are already far more exposed, it may be otherwise. Because -- taking cautionary note that the Rembrandt investor plaintiffs were supported by a publicly-listed company whose business is the funding and financing of large-scale class action securities litigation (here) – the investor-protection bar is a ruthlessly effective learning organism – to which the Judge’s liability language will operate like a blood-soaked invitation into a shark tank.

Even if not in the already-fraught American litigation market, should her process of hindsight negligence analysis gain traction in the courtrooms of Europe and elsewhere, the large accounting firms will find no ready firewall against the spreading conflagration.

 

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Sarbanes-Oxley, Ten Years After -- Are We Having Fun Yet?

It has not been difficult, through this summer of discontent and turmoil in the world’s financial markets, to ignore with enthusiasm the comprehensively vacuous observations of the tenth anniversary of the Sarbanes-Oxley law. 

Readers will recall my long-held skepticism about that knee-jerk post-Enron exercise, going back to my July 20, 2002 observation in the International Herald Tribune about the preliminary Senate vote, that “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

Nor has the decade horribilis given any reason to change.

Of the smug and fatuous self-congratulations of the bill’s eponymous sponsors (webcast on July 30, 2012), the less said the better. As the English essayist Charles Lamb wrote about a blame-worthy poetic effort:

“It would be an insult to my readers’ understandings to attempt anything like a criticism on this farrago of false thoughts and nonsense.”[1]

Rather, some unasked questions should be advanced.

Regarding the self-interested back-patting of those with careers to be served by the inflictions of Sarbox –- the PCAOB’s members and staff and the spokesmen for the accounting oligopoly dependent on its compliance revenue:

“Would the elves in Santa Claus’s toy shop be expected to vote against Christmas?”

As for those purporting to see some claim of benefit, yet propounding no solutions to the continued eruptions of financial chicanery (here, here and here), the challenge remains that the cyclical nature of market bubbles makes inevitable a post-scandal period of cleansing and temporary return to virtue – political dynamics notwithstanding.  

Put another way, the storm of both scandal and outrage after Enron and WorldCom was bound to clear, no matter what. So instead of the wrong question, whether post-Enron corporate behavior is now improved, under both the Sarbanes-Oxley law and the law of unintended consequences, the proper operative question should be:

“Would financial reporting and assurance not be better if Sarbanes-Oxley had not been passed at all?”

First, American law since 1934 has pronounced it illegal to make false statements in connection with the purchase or sale of securities. So – as confirmed by the absence of prosecutions under the redundant Sarbox requirements for executive certifications of financial results (summarized by Michael Rapaport and Francine McKenna) -- that exercise has from the outset never been more than optics and cosmetics.

Second, a decade of PCAOB intrusion into the relationships between auditors and clients has engulfed the corporate reporting process in cost, paperwork and degradation of the assurance function (here and here) – while, into the bargain, failing either to advance coordinated global-scale assurance regulation and oversight in most of the world’s major capital markets (here) or to prevent (among others) the wave of securities malfeasance of off-shore origin, notably from China.

Third, as to the law’s centerpiece obligations on internal controls reporting and assurance, it was always true, even pre-Sarbox, that most decently-controlled companies would do reasonably well on compliance, most of the time – while a parade of horribles since then has made it clear that, for reasons of scope limitation or plain enforcement dysfunction, the law has been ineffectual against the rare but all-too-frequent and truly consequential cases.

A brief post-Sarbox sampler illustrates that – as generally true of large-scale challenges to risk identification and management -- it is the “outlier” cases that really matter:

• The control failures that brought down Bear Stearns and Lehman Brothers

• The “buco nero” at Parmalat and the ghost employees at Satyam

• The in-house looting by the chief financial officers of Koss in Milwaukee and the city of Dixon Illinois

• The undetected Ponzi schemes of Bernie Madoff and Alan Stanford, unremarked by gate-keepers, regulators and out-of-control client advisors and abettors alike 

• The valuation fantasies behind the window-dressing at Fannie Mae and Freddie Mac

• The incentives-driven perversions in the mortgage businesses models of Washington Mutual, Countrywide and New Century

• The derivatives and trading fiascos at UBS, JP Morgan Chase, MF Global and now Knight Capital

What then is the purpose of law-making? Sarbanes-Oxley has manifestly not ameliorated the flaws persistent in the nation’s corporate reporting and assurance structures -- then of what use or benefit has it been? 

And, if only the mis-leading politically-motivated placebo that it appears, what more should be expected both of our elected representatives and of those aspiring to hold them to account?

 

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[1] “On the Tragedies of Shakespeare,” 1811.

Disintegration of the Big Four Audit Firms? As They Tell the House of Lords, "We Don't See That on the Horizon"

The epitaph for the private delivery of audit services to the world’s large global companies was written in London on November 23.

During its generally amiable ninety-minute stumbling around the topic of auditor concentration – available here and observed on here and here -- the House of Lords Economic Affairs Committee queried the invited heads of the Big Four, “You do share the general unease about the fact that it could be Four coming down to Three?”

For the quartet’s response, the senior partner of Deloitte’s UK firm, John Connolly, contributed this entry to the lexicon of the self-deluded: “I don’t see that on the horizon at all.”

Which will go down next to the grim valedictory of Citigroup’s Chuck Prince in July 2007, that “as long as the music is playing . . .we’re still dancing,” only months before his forced departure, or – closer to home – PCAOB chairman William McDonough’s concession in September 2005 that among the regulators, “None of us has a clue what to do if one of the Big Four failed.”

Although memorable language would not be expected from a “numbers guy,” Mr. Connolly’s invocation of an empty horizon has real resonance.

Military comparisons are inevitable – and instructive. General Custer did not foresee danger from the invisible Indians. The American forces at Pearl Harbor were heedless of the approaching Japanese. And to Hitler, the beaches of Normandy were both well-defended and bare of Allied threat.

While in this decade’s uniquely impactful if unforeseen event, nineteen Saudi thugs with box cutters in their backpacks begat a world-wide season of terror, destruction and disruption, the effects of which have altered history.

As with these examples, and the grievous lessons that emerge only in the hindsight of the short-sighted, Mr. Connolly’s handicap is the limit on his vision – because a clear view of a blank horizon is of little value if the surveyed circumference extends no farther than arm’s-length.

I am indebted to my friend Shyam Sunder at the Yale School of Management for the Sanskrit folk tale of koopa mandooka – the “frog in the well”, which lives in blinkered comfort so long as confined within the boundaries of his closed little world.

But should he venture forth, the perils of the world outside are unknown. It may indeed be a paradise, full of succulent insects and comfortable lily pads and luscious companions with which the frog can disport and sire entire populations of little tadpoles.

Or, it may be a hell of deadly predators – voracious snakes and hawks and sharp-toothed fish. Or a searing desert beyond the fringes of the oasis, where a clueless frog will be pan-seared in minutes.

Unless informed and prepared, the frog in the well has no way to differentiate a prosperous future from one of mortal danger.

And the consequences of his ignorance are just as fatal as those of being wrong.

Here’s what the Big Four leaders might have said, in answer to the Lords’ call:

“We not only share your unease. We are terrified for the survival of our firms – not so much for our generation, who if fortunate may hope to ease soon into retirement, but for the future of a profession that depends for its sustainability on the talent and commitment of our younger personnel.

“Our ability to provide valuable assurance remains important to the capital markets. But it must evolve beyond the binary choice, whether or not to pronounce “true and fair” -- a choice exposed in the banking crisis by our delivery of unqualified audit reports on soon-to-fail institutions as not only unresponsive but affirmatively dangerous.

“Yet we are shackled to obsolete reporting by regulatory requirements confining us to an unhelpful commodity product. What is needed is no less than a fundamental re-structuring, under which:

• “Supplanting the current report form which no longer serves a useful purpose, we could tailor our reports to the real needs of particular users.

• “Our ability to deploy a full range of services would include access to the expertise of non-audit personnel to achieve more sophisticated performance and improved quality.

• “The interests of investors would be reasonably supported by government oversight, enforcement and protection such that our reporting would not create liability exposure of a magnitude that would destroy us.”

They might have said that. But they didn’t. For want of a vision extending to that far but visible horizon, a golden opportunity was allowed to pass. 

 

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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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The EC's Green Paper, "Audit Policy: Lessons from the Crisis": The Bureaucrats Blow Another Chance

  

  "We've gotta do something, They"re serious this time.

    "You know what we gotta do. Toga party.

    "We're on double secret probation, whatever that is. We can't afford to have a toga party.

    "You guys up for a toga party?"

            -- "Animal House" -- 1978

  As the October 13 release of the European Commission’s Green Paper, “Audit Policy: Lessons from the Crisis” – here -- by rookie Internal Market and Services Commissioner Michel Barnier, illustrates:

Any newly-arrived bureaucrat, tempted to launch the machinery of inquiry, should first demonstrate the need for further admiration of an already tediously-explored agenda, and the vision and will to do more than re-plow the same sterile ground.

The naïve tone in which the Green Paper articulates the role of auditors, and the clueless innocence of its “questions,” make evident another major exercise in resource-wasting.

The vacuity of leadership vision and reasoning on the grave issue of the viability of global-scale audit has been on view for years -- here -- and continues in Brussels:

The Green Paper starts with the customarily limp and tedious observations – e.g., that audit “provides assurance on the veracity of the financial health of all companies,” and that “continuity in the provision of audit services to large companies is critical to financial stability.”

But this exercise in self-congratulatory amour-propre is empty. Its adherents have never known a world in which public company financial statements have not borne the commodity appliqué of the one-page standard auditor’s report. The alternative proposition, of life without the legal requirement of an audit – an obligation that survives only by force of law, not by market choice – has never been tested.

No less, the last of the weak and aging dinosaurs on their terminal descent into the tar pits no doubt had themselves persuaded of the vital centrality of their role and influence in their ecosystem -- just as the tidal wave of unstoppable evolution was gathering to wash them to oblivion.

Consider a few examples of the Green Paper’s tiresome re-cycling of old material (question numbers are kept; some wordings are streamlined):

Can smaller firms emerge to become viable participants in the large-company market segment (# 27):

Would someone please do the arithmetic? Assume the impossible – that all the small firms doing any public company audits were merged into a single practice. That unmanageable monstrosity would still be smaller than the smallest of the Big Four.

Just as the case has never been made that smaller firms can deliver competitively superior quality of service, their limitations of geographic scope, breadth of expertise and capacity for risk tolerance are disabling to the notion that a Big Fifth can be either grown or built. And their leaders willing to be candid will admit it.

Should alternative structures be explored to allow audit firms to raise capital from external sources (# 23):

A better question: did anyone with business literacy vet the Green Paper? The Big Four capital structures, with their modest partner investments and operations financed by their client receivables, do not need and could not deploy major outside capital if handed over on a platter (here). Rather, such funds would only be a honey pot to attract the further attention of potential litigants.

Would contingency plans, including “living wills,” address the systemic risk of a large-firm failure (# 31):

First advanced in 2008 as part of the cringe-worthy output of Treasury Secretary Paulson’s Advisory Committee on the Audit Profession, this trial balloon deflated without lift-off (here) – for the obvious reason as shown by Arthur Andersen’s rapid disintegration in 2002, that the death spiral of client and personnel flight, once started, is irreversible.

Should audit mandates be limited in time (# 18), or should rotation be mandatory (#29):

To this, the complete one-word answer has always been, “Italy.” The only country of any significance with mandatory auditor rotation – a land capable of producing neither enough children to sustain its population nor enough honest politicians to sustain functional government – did manage to produce the scandal of Parmalat – world-class malfeasance enabled by the rotation-inflicted division of audit responsibility between two firms. Enough said.

Are there benefits to joint audits or consortia including smaller firms (# 28):

The French structure of joint audits is argued for, but is profoundly unsatisfactory as a persuasive example – perpetrated as it is by the lobbying of the small firms’ nationalistic appeals to preserve a miniscule local slice of the world market.

The fanciful notion that minor rump-end participation in an otherwise global-scale audit engagement could give a small firm the muscle to supplant a failed Big Four firm is belied by the record: at present, every audit of the CAC 40 is led by a Big Four firm. If small-firm consortia were credible, there would already be at least one example in practice.  

Finally, should audit appointments and remuneration be managed by government (## 16-17):

Consider this long step down the short road to nationalized audit agencies. Nowhere else are markets for commodity products, other than audit reports, subject to such artificial constraints – whether auto manufacturers, retail bankers or espresso vendors.

Yet if viewed as a legitimate target for government take-over, audits performed by low-grade civil servants -- the only ones to find appeal in such a career post -- would descend in value and repute even further to the level of nationally-administered postal delivery, rail service and health care.

It’s all too depressing, to belabor these points yet again. But since Commissioner Barnier looks as green as his paper, the only hope is to administer sunlight and fertilizer and pray he ripens quickly.

 

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In the News: Crain's Chicago Business on the Funk Pervading the Accounting Industry -- And My Five-Word Quote

 

Steve Strahler reports in yesterday’s edition of Crain’s – here – that “revenues are down, margins are squeezed and many employees are unhappy” – especially at the Big Four, where the combination of recession and exposure makes for a zeitgeist of uncertainty and dissatisfaction.

For which, a tip of the hat.

And another for compressing one of my central themes into a quote of record-setting brevity, on one of the fundamental but underexplored issues threatening the viability of the large firms: “They’re not capitalized to survive.”

 

And those who persevere will see a modification of the cliché: Five words is worth a picture. 



Guest Post at the FEI Blog: When Litigation Kills the Accounting Profession -- Don't Say You Weren't Warned!

Edith Orenstein's FEI Blog is a "must read" -- a thorough and lucid map of the goings-on in Washington among the  legislators, regulators and agencies of law enforcement. I have the pleasure this week of taking up Edith's kind invitation for a guest post, while she is on vacation:

With the devilish details of the Dodd-Frank Act now to be worked out and many special interests weighing in, legislative activity in the American financial sector returns to a standstill – probably until after the elections of November 2012.

So what would bring to the forefront a topic that to most is sleep-inducing, although it keeps some few from sleep: namely, the very viability of the large accounting firms and their fragile franchise to audit the world’s global companies?

Nothing less, presumably, than an existential shock to the stability of one of the Big Four tetrapoly – an unresolvable criminal investigation or a “bad case” outcome in one of their nightmare civil cases. . . . . For the entire post, and to see the scope and quality of Edith's own work -- please see here.

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The Big Four's UK Firms Pick Up Non-Executive Directors -- And Then ...?

All the girls get prettier at closin’ time –

                    Mickey Gilley, 1976

A recent discussion with Re: The Auditors about the governance of the large global accounting firms was triggered by the UK news that the Big Four were appointing non-executive directors (here), as contemplated under the Audit Firm Governance Code published in January by the Financial Reporting Council (here).

Francine McKenna’s blog post (here) included my own skeptical two cents worth, on the unlikely effect on the culture of global-scale private partnerships, and the limited impact of single-country endeavors. It also led to these further pessimistic reflections on the reasons why the FRC’s efforts – however noble and well-intentioned – will create no traction in favor of the firms.

A starting point is with the process itself: a task force was assembled under the auspices of the auditors’ own trade group, the Institute of Chartered Accountants in England and Wales, comprising four members from the accounting firms, seven from large clients and a single academic. So as to the question of “regulatory capture”:

Would you expect roast goose for Christmas dinner, if the flock got to vote on the menu?

More important is a proper apprehension of the role of codes of conduct and ethical charters and all the accompanying high-toned rhetoric. It’s the common confusion of cause and effect, to view these as drivers of responsible corporate governance.

The contrary is readily observed. Governance-challenged enterprises from Siemens to AIG to BP could claim the vigor and piety of their pre-lapse structures, and Enron was lauded for years as an American model of behavior.

The FRC’s code (here) rightly identifies the importance of executive “tone at the top” – but its induction runs the wrong way. In truth, when company leadership really does “walk the talk,” its employees are infused and its community is served in praise-worthy fashion -- codes and charters follow with credibility.  

Not only can good governance not be inflicted or imposed, in other words, because resistant leaders will find ways to disturb or subvert the purpose, but a virtuous culture will display its legitimacy without the need for pietistic overlays.

So the FRC is on the back foot in at least these ways:

First, the Code makes persistent reference to the non-executives’ presumed “independence,” but recitation and reality do not engage. As contemplated, newly-engaged worthies will be compensated under employment contracts, provided with staff and resources by the clients, and insured and indemnified for their conduct – putting them under far closer relationships than the large audit firms are permitted themselves.

Second, the FRC proposes that non-executives might facilitate communications and reduce exposures when the large firms face existential threats from litigation, regulation or prosecution. As floated briefly at the US Treasury Committee on the Audit Profession in 2008, the suggestion of stand-by management replacement under similar conditions displayed a Panglossian naïveté that thoroughly deserved its criticisms (here). But rebuttal need not go so far. If “tone at the top” is to be successful in a crisis, it has to be engaged first-hand – not insulated or protected by proxies, delegates or intermediaries.   

Finally, the Big Four firms already have an agenda of opportunities to address the credibility gap with their critics, none of which involve the cost or distraction of bloating their boardrooms with outsiders drawn from the available ranks of the great and the good:

• Arguments about the safety and soundness of the Big Four are going nowhere without their publication of audited world-wide financial statements. Single-country information, of the type now available in the UK, leaves unaddressed the implications of strategic directions, personnel deployment and risk and quality exposures that span the globe.
  
• No progress is possible toward a sustainable business model resistant to deadly litigation exposure, so long as the large firms limit their advocacy to summary data and hand-wringing by their messengers -- as witness the sterile paralysis of the Paulson Committee (here). If inflicted on a Big Four firm, the $ 3 billion cost-to-date of BP’s exposure to Deepwater Horizon would already have been fatal (here) – a message supportable only by an available public acknowledgement of the specifics of the large-firms’ list of death-threats.
• Relatedly, it is past time to recognize that the energy devoted to narrow-focused “liability reform” and “damage caps” is a wasted effort – not only as a political non-starter in every major legislative venue, but as unsatisfactory to achieve sustainability. Legitimate structures for investor protection cannot in the long run be built on the narrow base of the accounting firms’ partner capital – the resources are simply not there – but require instead the presence of government as a resource of last resort.
  

To the extent any of these require more fundamental re-engineering than that offered by the FRC and the ICAEW – and they do – so be it. 

 

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Sarbanes-Oxley and the PCAOB: The Supreme Court's Own Goal

On this last Monday there were two non-events, both with heavy political overtones:

First was the announced resignation of Jean-Pierre Escalettes, president of the French soccer federation, after Les Bleus’ disgraceful crash out of the first round of the World Cup with two losses and a draw.

Second, by a five-four vote (here), the United States Supreme Court upheld all significant aspects the Sarbanes-Oxley law of 2002 and the structure and operation of the Public Company Accounting Oversight Board, save only for the means of removal of PCAOB members.

There was always something strained and artificial about the constitutional attack mounted by a dinky accounting firm and an anti-Sarbox advocacy organ, raising points of eye-crossing abstraction about the scope of presidential power to appoint and remove subordinate officials.

So perhaps not surprisingly, the Court’s constipated decision is in kind – leaving entirely in place the law, the agency and its members, and satisfying nobody except court scholars perched in the highest of ivory towers.

Because, for all the anticipatory sound and fury --

• There is this much disruption of the PCAOB’s business: None.
• There is this much need for legislative re-visiting of Sarbanes-Oxley: None
• There is this much likelihood that, with Congress on its way to summer recess and mid-term election season around the corner of the calendar, there is any political appetite to take up the multiple short-comings in the present scheme for the regulation of the delivery of accountancy services to public companies: None.
  

For completeness, however, although the nature of the status quo has been righteously endorsed as robust, across the spectrum of the satisfied – from the Sarbanes-Oxley authors themselves (here) to the lobbying arm of the large accounting firms (here) to the head of the increasingly marginalized AICPA (here), to the SEC chairman herself (here) –

• Eight years and billions of dollars down the Sarbox drain, the amount of demonstrably beneficial deterrent effect on the global financial crisis and the performance of the principal actors: None.
• The extent to which the cries for revisions in the PCAOB’s remit or ability to act effectively in relation to the global market for useful and valuable audited financial information (see, e.g., my friends Francine McKenna and David Albrecht) have any chance of achieving results: None.
• The probability that rational heads will constructively address the existential crisis facing the survivability of the Big Four’s franchise of privately-provided assurance to global-scale companies, ahead of the catastrophic collapse of their business model: None.

Scholars of the Supreme Court’s deliberations will debate endlessly the nuances of its powder-puff result. Meanwhile the conversations amongst the Court’s majority wing can be re-constructed thus:

“We can’t let this law stand. When the Constitution was written, independent auditors hadn’t even been invented. This is not the crystalline path of our gun-control logic (here), from muskets in the militia to Uzis in Starbucks.”  

“No, but if we trash the whole statute, just think of what Chris Dodd and Barney Frank might legislate in its place, that we might just have to live with.”

“Right. Scary. And our Wall Street friends are living just fine with an agency that is toothless and clueless.”

“So if we do as little as possible, it may not resemble intellectually honest conservative orthodoxy, but it might just sell as restrained and reasonable.”

“You’ve got my vote, Chief. But only because we can’t bring back the guillotine.”

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Seidman Gets a New Trial in Bankest -- And How Does Winning Feel?

“Never mud-wrestle with a pig. You end up covered with pig-shit. And the pig actually likes it.”

There was palpable relief on June 23 in the halls of international accounting network BDO’s firm in the US, née Seidman. The Florida Court of Appeals, reversing a potentially devastating $521 million jury verdict, ordered a new trial of the claims by Banco Espirito Santo relating to alleged faulty audits of the irregular accounts of Seidman's factoring company client Bankest.

Updating earlier attention to this threat hanging over Seidman’s existence since 2007 (here, here and here), it is now right to look beyond the predictable chest-thumping press releases of the adversaries (see here), and contemplate just who has won what.

Notably, to start, Seidman lives to fight on.

Even though the opinion (available here) makes clear that the appellate court would not have let stand the $321 million in punitive damages imposed by the jury for its finding of Seidman’s egregious conduct, the Seidman firm was still facing disintegration. Being forced to pay only the $159 million of compensatory or “ordinary” damages would have inflicted on its 273 partners the unsustainable obligation to work for nothing for a year or more (based on industry profit margin data and Seidman’s reported fiscal 2009 revenue of $620 million - here). 

Dealing not with the merits, but only with the defects in procedure it found in the lower court’s trial management, the appellate tribunal held that the claims of Seidman’s grossly negligent conduct were inextricably “intertwined” with issues of “causation, reliance, and comparative fault” – that is, in lay terms, that Seidman’s allegedly bad behavior should have been evaluated by the jury in context of the bad behavior of all the other actors in the sordid story of Bankest.

So the press-release confidence of Seidman’s CEO, that it “acted at all times consistent with its professional obligations,” has been neither established nor vindicated, but remains to be re-tested in another fulsome public proceeding.

As for the Banco plaintiffs, the obligation to re-try the case is another reminder of the lawyers’ caution, to be careful of getting your wish from a trial judge. A lawyer who rings the bell for a huge jury verdict, when the judge has put the bell-rope in his hands, may walk with a little more clank in his swagger. But a judgment only really counts as bankable when affirmed on appeal and collected.  

And while both sides will claim to have learned of their courtroom strengths and weaknesses from the original trial, the very rationale of the appellate rulings that require a new trial also gives a road-map for the other side by which to by-pass the perceived speed-bumps the first time.

So with the learning process a bi-lateral one, another go-round will feature re-treaded strategies on both sides.

Which reinforces the attitude of courtroom veterans, that second trials have the inevitably stale air of re-cycled themes, witnesses and evidence – the very reason they happen so seldom.

That sentiment plus traditional analysis suggest that, under the appellate court’s signals about the extent of the penalty against Seidman that it would sustain, the parties will reach a settlement – one that to Seidman would be highly painful but tolerable – in effect, the number of months its partners might stand to work without take-home pay before they bolt for the exits.

On the other hand, trials of life-threatening claims against the large accounting firms are so rare as to make impossible either patterns or reliable predictions.

The Florida court did make one observation of unintended and presumably un-ironic import:

“An accounting firm that must distribute its net income and net worth to judgment creditors rather than the partners who produced that income will not have partners (or clients) for long.”

In other words, even a small state’s intermediate judiciary recognizes that so long as the large accounting networks are put to the hazard of litigating for their survival, the entire global franchise of privately-provided assurance is at risk.   

Critics of that structure, who in essence dispute the very legitimacy of the firms’ business models (here), remain challenged to articulate an achievable alternative that will offer sustainable value to the community of financial statement users.

If the prolonged and now-extended agony of Bankest teaches nothing else, it is that the auditor-viability dialog is still not satisfactorily engaged.

 

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What's the Future of Audit? The Discussion Begins to Get Serious

Anyone doubting the central role of accountants in human civilization need only recall that some of the oldest exemplars of proto-writing were not love poems or heroic fables, but inventory records – tallies of Sumerian grain and livestock etched into clay tablets.

From the dawn of our history, when barter was supplanted by the earliest forms of money and future payments were first promised for present performance, there has been the need to choose and apply accounting conventions – including those for financial derivatives.

But although the independent audit function emerged with the innovative Victorians – see the pioneering of William Welch Deloitte’s succinct opinion of 8 February 1850, “audited and approved,” on the half-yearly accounts of the Great Western Railway – the profession cannot escape the inexorable forces of evolution and change.

Survival threats to the large accounting networks and their provision of assurance on the financial statements of global-scale companies are profound. But public recognition of the gravity of the issues has been slight, among the user community and the mainstream media alike, and there is no credible evidence of leadership in the search for achievable solutions.

This week, blogger Caleb Newquist’s two-part series at Going Concern – “Why a Big 4 Failure is Imminent – And What It Will Mean” and “What Will the Aftermath of the Next Big 4 Failure Look Like?” – draws together my views and those of Francine McKenna of Re:The Auditors. 

Although the three of us bring differing styles and perspectives to our respective audiences, the point is not unanimity but the presence at long last of real dialog – desirably to be joined by the entire roster of interested constituencies.

Your attention is invited, and your reactions are welcome.   

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Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations

“No such thing as a failed experiment …. only experiments with unexpected outcomes.”-- American engineer-architect R. Buckminster Fuller

 Is the Big Four’s concentrated control of large company audits a real problem? Persistent voices of concern and attention extend back at least to the 2006 study for the Financial Reporting Counsel (here), recently joined by global leadership of BDO and Grants (here and here).

If so, is there a credible case to incentivize their exchange of market dominance for liability limitations?

Those issues were addressed this month in a paper from the American Antitrust Institute – here. In an all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With pending claims totaling billions of dollars, the Big 4 audit firms face serious threats to their survival…. (L)iability exposure substantially exceeds the combined partner capital of the Big 4 firms… (They) contend that liability limits are necessary to prevent the loss of another Big 4 firm, which would throw the global financial system into chaos. (footnotes omitted)   

The AAI’s suggestion would be a legislated trade-off: “government incentives to break up the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned on a firm divesting itself of, say, 20% of its domestic revenue and the personnel serving the surrendered clients.

Can’t work – because of the many problems with the underlying but unachievable assumptions. 

But before getting there -- the AAI deserves credit at least for recognizing the completeness of the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250 million” (emphasis in original) – with even tighter limitations on auditor choice in such industries as metals and mining, energy, air transportation and financial services.

Start with the political unacceptability of liability capping at a level that can assure Big Four survival. I have spelled out before (here) the financial limits of the large firms’ private partnership structure and their membrane-thin working capital, under which they cannot withstand litigation shocks above the $1 - $2 billion range – a tiny fraction (by either amount or percentage) of the exposures in their pending lawsuit inventory.

As the AAI paper summarizes, critics of liability protection point to the firms’ average litigation payouts, as a percentage of revenues and as compared to the far larger total of alleged damages. They fail to recognize – as do the arguments for capping from the profession itself -- that averages are meaningless when the “outlier” of a single verdict, falling outside the misleading comfort zone of a bell-curve model, could and would be devastating.   

So: because American politics offers no cover for protection at those levels, that side of the proposed AAI bargain is no solution. What of the other side -- the plausibility of large-scale competitors emerging from the suggested divestiture program? The facts dictate otherwise.

First, an abundance of small practices already exist. Why they have not coalesced into global-scale practices is a long-familiar story of limited geographic scope, expertise, risk appetite and readiness to invest.

Second, the smaller sector does not inspire confidence in its strength or capacity for quality growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a deathwatch, facing the post-appeal enforceability of its $521 million jury verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins just received a seven-year prison sentence – now faces the fall-out of being fired by Koss, its public but family-dominated Milwaukee client, whose CFO managed for years to steal amounts in excess of the company’s total net revenue (on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a practical matter, how would global-scale competition emerge? If a Big Four firm were to hive off a small geography-based practice, that newcomer would suffer handicaps of capacity and expertise no different that those of the current smaller firms.  If a large firm were to shed an entire industry practice, no new competition is added to serve that industry. And if instead, it were to divide a viable large-scale practice, then each of the two sub-practices would be burdened with shortages of expertise, personnel and the capital strength necessary to build to scale and withstand their risks.

In summary, the AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in logic I described (here) in the comparison of a failing situation against an idealized state, without recognizing that the assumed achievement is impossible under real-world limits, flaws and constraints.

The large firms grew that way for service-based reasons. And dreams of expanding the population of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the AAI’s most seriously under-examined assumption is that the “catastrophic” disintegration of another Big Four firm “would throw the global financial system into chaos.”

Why so? To the contrary, if the now-standard auditors’ report were suddenly not to be obtainable from any source, who would miss it?

Regulators and politicians would have convulsions, to be sure. But as the financial crisis itself has shown, that is daily practice for office-holders in the hermetic confines of Washington and London and Brussels.  

Should the stock exchanges be closed, if a Big Four failure meant that one-quarter of the large listed companies lacked an audit report? Could those companies’ securities be barred from trading? Unthinkable. Out where capital really flows and trade is actually engaged, the world’s markets would shrug, start the process of designing new forms of assurance from a blank page, and move on.

And the splintered pieces of the former Big Four would provide ample building blocks for a new assurance structure – without, pace the AAI, any need or use for the unintended and unpredictable hazards of another failed experiment.

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