• “When” Another One Bites The Dust

    By • Jun 23rd, 2008 • Category: Pure Content

    I say “when” not “if” since Jim Peterson and I agree most strongly on this:  

    Another large firm will fail soon.   

    Soon, to me, means in 1-3 years, not 5-8 or 10-13. 

    Jim and I had a long talk about a week ago over pancakes and waffles.  We usually have a nice leisurely lunch, replete with more than one choice of wine and strong espresso and dessert to cap it off.  But we knew the subject was “failure” and so we planned a breakfast, with plenty of carbohydrates and caffeine.
    Jim is very strongly a “blank sheet of paper” kind of guy when it comes to devising solutions to the problem of audit scandals, audit firm catastrophic litigation and poor audit quality.  When I think about it, I tend towards the “we can fix it if we all try hard enough” perspective.  It comes from my experience as a “blank sheet of paper entrepreneur.”  If I have to do the work, I’d rather start with something, however broken, and fix it, than start from scratch.  
    Can the firms be fixed?  
    Well, I think the model is certainly broken and the objectives, goals, and incentives on cross-purposed, contradictory and opposing sides.  My usual rallying cry is, “Make the firms step up and meet their professional obligations.  Take away the oligopoly protection (hence my opposition to liability caps.)  Let some fail in order to clean house and bring market discipline to the firms. ” 
    Yeah, capitalism and market discipline.  That’s the ticket. What rationally self-interested Ayn Rand follower can disagree with that?
    We should bring the questions back to investors:
    What do you need in the way of financial reporting assurances, audits, due diligence, attestations?  Does an audit and its useless, boring boiler plate make a hill of beans difference in your investment decisions, or do you all, analysts, sophisticated investors and other stakeholders, make your own decisions based all publicly available information assuming it’s timely and accurate?  Can we find a way to uncover fraud, punish fraud and warranty the financial information that is distributed to the public so that financial statements are a tool rather than a throwaway?
    I offered you a chance last week, via the blogger survey tool, to voice your opinion on the next firm to fail.  I was surprised and pleased with the results.  First, I was pleased that so many took the time to respond. There were  173 responses over a five day period.  The choices were:
    BDO Seidman (Primarily due to the judgement against them in Florida)
    Grant Thornton (Primarily due to Refco and Parmalat litigation pending)
    KPMG (due to New Century potential litigation primarily given their still fragile state)
    PwC (given their Northern Rock, AIG and Refco issues)
    I could have given you a choice of many others including Deloitte, EY, or McGladrey and Pullen.  
    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.

    (For details on the litigation report provided to the ACAP by the Center for Audit Quality, take a look at Edith Orenstein’s post on the FEI blog today.)

    I was surprised at the result of my survey, since I believe BDO is the closest to death’s door.  I received an email from a source recently that said, “…the vultures are hovering”:

    Heard yesterday from an insurer that BDO will likely pay some amount. This person works for a leading insurer of accounting firms. The company does not insure BDO, but other mid-tier firms. Take it for what it is worth, an educated guess from someone in the industry.  

    He also told me that other firms, most likely mid-tier firms, have made inquiries about hiring BDO employees in the case of its failure.

     


    So it was  a surprise when reader opinion said something different:

    Which firm will be the next to collapse?

    KPMG (New Century case)
    65 (37%)


    BDO Seidman
    49 (28%)  

     

     

    PwC (Northern Rock and AIG)
    37 (21%)  

     

     

    Grant Thornton
    22 (12%)

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    16 Responses »

    1. Francine:
      Shall I call you Dagny from now on? KPMG all the way!

    2. I know I am always on here saying something you disagree with. I am not going to break the trend today. The market cap. of the largest companies continues to grow and grow. If you don’t cap liability in some way, the largest companies are simply unauditable under the current model. The only thing I could think of is to diversify the risk, that is two or three auditors jointly auditing the largest companies. However, that would be a coordination nightmare. Firms can hardly coordinate the audit on their own, let alone when you double to quadruple the partners in the kitchen.

    3. @Anon Please keep commenting. If you could make up a pseudonym, I would know it’s you and then appreciate the dialogue…

      We actually don’t disagree. You said, “the largest companies are simply unauditable under the current model…” The difference is I don’t think liability caps are the answer. It’s the model that’s the problem. The firms can’t lose. And the fact that the large global multinationals will always be one step ahead of the the auditors. They have to be. It’s their business.

    4. So what’s up with PwC Japan? Are you following this for your loyal readers?

      http://www.theaustralian.news.com.au/story/0,20867,19115194-36375,00.html

    5. @Anon Lots of articles about PwC Japan. Just take a look at what comes up with this search. http://www.retheauditors.com/search?q=pwc+japan

    6. Anon:
      I agree with you. Under the current system, large publicly-held firms are unauditable. I read the proxy statements I get and sometimes look at the audit fees. Sometimes I think they are reasonable. Other times I think, “for $XXXX, dey didn’t do nuttin”. So?
      If the craven Big 87654 partners believed the current system is unworkable, let “em say so. Or shut up. Let them refuse the business? Do they? Face the music “BOY”, Big 87654 partners are in many instances irresponsbible clerks who want to get paid for doing nothing of substance and just “going through the motions” of audits. They are “tick and tie” guys. If PWC refuses the say, ExxonMobil audit under the current model and so do the other Big Four, let Exxon approach other firms. I assure you, at some price a group of smaller firms will audit Exxon.

    7. Rather than offer an audit opinion we (the firms) should simply sell insurance. Our opinion would state that we insure the finacial statements against errors of more than $y for up to $x. Maybe a minimum threshold based on something like market cap to “protect the public” – or maybe not. If the board, lenders etc. decides they need more insurance or a lower error threshold they would have to pay the firm more. The firms can carry out whatever procedures they want to underwrite and price the insurance. That’s right – no minimum standards of work or quality, no PCAOB, no nothing – but if you screw it up and miss something, there is a claim against you and you pay. No chance of bankrupting the audit firm assuming they price the insurance properly and are adequately reserved, and I think a more efficient market in many ways.

    8. @Anon Most recent Interesting idea having the firms write a straight insurance policy as a warranty type opinion backed by their own funds.. But if there are no min standards, then how will fin statements be comparable? The firms are essentially self-insured now. They pay the cash for a loss, either as a settlement or a jury verdict, out of their own pocket. They are uninsurable by normal underwriting standards. There are no insurance policies for the Big 4. The smaller firms have some coverage but it is minimal. In the case of BDO it is a fraction of the jury verdict that is hanging over their head, hence the death sentence if they lose the appeal and the death march right now.

    9. No doubt you are right Francine, there would need to be some standard setting body to ensure consistency of reporting (although the free-for-all would otherwise be glorious). And I don’t disagree we are writing insurance now, but with no limits and apparently poor underwriting. No wonder we give real insurers the vapours.

    10. Anonymous:
      A professor of accounting at New York University, whose name I’ve forgotten, suggested the “insurance” sales business 10-15 years ago. So far, no Big 87654 firm has offered the product.

    11. FM,

      I doubt if any Big 4 firm will crumble soon. Maybe some major embarassments, but not crumbling. From the Enron and Worldcom cases, it emerges that it takes criminal negligence from the auditors for a company to crumble, not some goof here and there. In addition, based on my recent experience within the Big 4, the partners are becoming increasingly paranoid by the day, closing all loops and sealing all holes, even when it is inefficient and unnecessary to do so, such as minor audit documentation issues. The audit industry is also unique in the sense that an audit firm can bungle issues, but the company/client still survives. In short, nowadays an audit is not really a value adding exercise, and hence a shoddy audit will not necessarily mark the demise of the client. And the large companies like GE & JP Morgan have excellent internal control environments, including internal audit functions, that ensure that the auditors add precious little value other than affixing an audit report to a set of financial statements.

    12. “Rather than offer an audit opinion we (the firms) should simply sell insurance.” This has been proposed before. I have seen some research. Perhaps from the NYU accounting professor Independent Accountant suggested. Maybe it was Dr. Baruch Lev? It’s an interesting model that should be revisited.

      Francine is also right about firm’s being uninsurable in the traditional sense. Even the large mid-tier firms create reserves for these lawsuits.

      Francine, I took your advice. I am “Chicago Accountant” now. Maybe I’ll set up an ID.

    13. Professor Ronen was the man behind the insurance idea. Interesting theory but not practical in reality.

    14. Also not practical is having 2-3 auditors on a client as suggested in the 2nd comment. The size of the big4 makes it impossible not to have conflict of interest for at least a few of the firms so clients kind of get rotated between them. It would be nice, from a competition and (if you believe in the power of the market) quality standpoint, to have the big87654 turn the other direction and grow in number.

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