Author: Caleb Newquist

In part one of our discussion, we discussed audit firm failure and why the business model is not sustainable in the current form. We will now look at questions about what the aftermath of a Big 4 firm failure could look like and what some various paths could be:

Why isn’t a “Big 3” audit firm situation sustainable?

Jim Peterson: The industry has gone from 8 firms to 6, to 4. We’ve reached a tipping point where if one more firm fails, the rest of them will get out of the business. The firms have all but admitted that the business model will not survive another failure.

Francine McKenna: The failure of a firm will also have global repercussion in various countries that are dominated by that firm (e.g. PwC in the UK). The remaining firms simply do not have the resources to pick up where the dominating firm left off.

Is government intervention a possibility and is it a reasonable solution?

FM: Personally, I’m in favor of at least a portion of public company audits being performed by the federal government, especially those public companies with a substantial investment by the U.S. Government. I wrote in a post from January 2009, “Let’s tear down the walls and rethink how we should protect the investor, who in many cases is now the taxpayer.” We should get rid of the for-profit audit firms’ involvement in the nationalized entities, except perhaps indirectly as contractors paid by the government but not controlling the client relationship. Those receiving government bailout funds could be “audited” by a team drafted from all able bodied audit and accounting professionals. I call it the National Service Corp for Accountability and Transparency™.”

JP: This is a possible scenario that may be imposed upon the world if proactive solutions are not formulated. Unfortunately, this will be imposed directly upon the U.S. Taxpayer. The product will have virtually no value and the efficiency and trust that would result could be likened it to any other service provided by the Federal Government.

You have both said that “no one would miss the auditors’ opinion.” When did the auditors’ report become such a commodity and is there any way for it to recapture any value?

JP: The auditor’s report as known and essentially unchanged since the 1930’s — an obsolete document. It has been a long time since someone asked sophisticated financial statement users, “What do you want?” and “What are you willing to pay for?” New ideas for assurance services are needed that will allow firms to provide a valuable product without submitting themselves to such huge liability.

FM: A completely different approach is needed, in my opinion, to protect shareholders and investors in public companies than the current product, especially when the shareholder/investor is the taxpayer as has occurred in the recent investments in AIG, Fannie Mae, Freddie Mac, Citigroup, GM, etc”

There are very few sophisticated investors – hedge funds, other large public companies, private equity or sophisticated creditors – who do not perform their own due diligence, using publicly available information or additional access prior to a merger or acquisition. They would be considered irresponsible if they only used the basic financial statements, assuming only the auditors opinion and required footnotes, as a basis for major investment decisons. So why do we expect the retail investor, the employee with their retirement savings in the company stock or a vendor or customer to count on the audited financial statements as the last word? Audited financial statements have certainly not provided any “assurance” that companies would not go bankrupt, that banks were solvent, that global financial institutions would not need hundreds of billions of dollars in taxpayer money to remain viable.

In the wake of the Andersen collapse, what hasn’t the leadership of large firms, primarily Big 4, done to mitigate risk to their firms?

JP: The leadership at the top has a lot at stake financially. They are focused on short-term integrity. The young partners will inherit this problem. The current leadership lacks both the vision to come up with solutions and the fortitude to make the decisions.

FM: I agree. The model needs re-invention. Most professionals that see the problems wake-up and get out or are forced out and their careers and lives are better for it. They don’t have to deal with the problem anymore. People that remain do so because they lose any idea of what else to do. They develop “Stockholm Syndrome” and some eventually become the leaders of these firms.

In an email, Jim Peterson wrote to us, “there is no silver bullet” that will fix this problem. It will take a “a holistic approach and an opportunity for “blank page” re-engineering can hope to address the relationship among all these elements.”

The idea of a wiping the slate clean and starting completely over is difficult for anyone to get his or her head around. Explaining the situation to a multi-billion dollar industry that has been doing “business as usual” for decades is even harder.

But what is clear is that the situation must change in order for the profession to become relevant and valuable again. Eventually, whether by way of the current litigation or other unforeseen events, the failure of the audit firm business model is unavoidable. With some many people calling the profession into question now again, the best thing that young leaders can do is start thinking about solutions now. The profession must re-invent itself in order to serve stakeholders as intended.

In the wake of the Lehman Bankruptcy Examiner’s report, speculation about the future of Ernst & Young is rampant, as is the future of the audit profession as another colossal failure raises questions about the relevancy of Big 4 firms’ audits of public companies.

While many are focusing on the “who” and the “how”, there is a small band of experts that are focusing on a bigger issue. (Yes, there’s a bigger issue.) That is, what happens in the aftermath of the next Big 4 failure?

To put it more clearly, what will another firm failure mean for the audit practice business model? How will the markets react? Will the government attempt to intervene in some
These are questions that will have to be addressed in the post-failure environment, despite the desire of the Big 4 for the problem to magically resolve itself.

In order to try and give you an idea of the possible fallout from the next Big 4 firm demise we asked two experts to expand on their past writings, discuss the current environment, and to speculate a little about the future. We discussed this topic with our own Francine McKenna and Jim Peterson after poring over a dozen or so of their past posts, exchanging a multitude of emails and one very spirited conference call.

Francine’s recent post, “Ernst & Young Looking at More Civil and Criminal Liability for Lehman Failure” examined E&Y’s civil and criminal vulnerability as a result of the Bankruptcy Examiner’s report. She is a skeptic of audit firm relevancy and never put it more poignantly to her readers than in January 2009, “So, you may finally be saying to yourself: What’s the point of audits and auditors?”

Jim Peterson’s blog Re: Balance is dedicated entirely to the subject of the next Big 4 failure and what it means for the financial world. From the “Why this site” section:

A basic re-ordering of the relationship between large global companies and their accounting firms is inevitable — evolution can be postponed, but it cannot be stopped. But the need is neither well recognized nor openly discussed — the very reason for this site.

While the question of the possibility of a firm failure is moot when you seriously consider the items outlined below, the question of “which firm?” is also of little consequence. And to take it one step further, the timing of a large-scale failure is a pointless discussion, as Jim emphasized, “The axe that could fall on any of the firms, depending only on the pace of litigation management by the judges over-seeing their dockets.”

Jim presented us with five reasons that the audit franchise’s very existence is ineffective:

Accounting rules are politicized – The FASB and IASB have been belly aching for awhile now that political influence needs to be left out of accounting rules. The reality is – a reality that both the FASB and the IASB have not yet accepted – this is a fruitless exercise, “Accounting principles are not in the profession’s influence, much less their control, but are politicized and complex, and are subject to manipulation by issuers,” says Jim.

Users’ expectations are not achievable – Somehow everyone in the world – and audit firms are partly culpable here — got the idea that financial statement audits guarantee good information. Jim says, “Users’ expectations are set at zero defects – partly the fault of the profession for over-selling its capability and contributing to the so-called ‘expectations gap’ — a level that is not achievable in any system designed and run by human beings.” In other words, to remain competitive, audit firms gave the impression that they could deliver highly effective results with their audits. By their own inability to effectively explain the purpose and the pitfalls of financial statement audits (until they are on the defensive for failures) the profession has sealed its fate.

Hindsight puts the firms in a bad position when liability is determined – When a firm makes a mistake, the media, politicians and “experts” are shocked — SHOCKED! — that auditors could have missed these errors. This makes for an easy argument before jurors that typically do not have a good understanding of the risks involved prior to an audit occurring. “The legal standards for liability in the major countries, especially in the US, are elusive and subjective; they expose the firms to second-guessing by juries – when ‘after the fact’ means after events that are ugly and there have been visible eruptions of misbehavior. That means ‘bet the firm’ cases cannot be [effectively] tried.”

The liability is, simply put, HUGE – Jim sums it up: “The Big Four firms lack the financial capacity to answer multi-billion dollar exposures…and so they are forced either to pay settlements that are ultimately crippling to their business model, or to go to trial in ‘bet the firm’ environment.”

The vicious circle self-perpetuates – There will continue to be huge audit failures. The firms have not identified a solution, largely because they have not addressed past mistakes with substantive solutions. “The large firms continue to fall into claims of deficient performance — examples of which have continued to arise with depressing regularity despite protestations of improved regulation and performance — in no small part because the profession lacks a forum for real ability to learn, or to avoid repeating the same old mistakes of the past,” says Jim.

Francine also mentioned something many people in the profession forget or don’t realize at all, and that is that a failure could arise unexpectedly from a non-U.S. jurisdiction, “a regulatory action in another country that no one in the U.S. is expecting could be just as crippling to one of the firms as any of the problems in the United States,” she told us. The most imminent risk comes from the Satyam scandal that occurred in India on the watch of PricewaterhouseCoopers.

The problem that the entire financial community in the U.S. finds itself in — not just the Big 4 – is that they are “locked into this arcane method of assurance,” according to Jim. The text of the auditors’ opinion has been essentially unchanged since the 1940s while the rest of the business world constantly evolves.

Stay tuned for part two of our discussion with Jim and Francine that will try to paint a picture of what the post-failure environment could look like.