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.