Jim Peterson, who blogs on the auditing profession, has written an excellent summary and analysis of the failure of the U.S. Treasury's Advisory Committee on the Audit Profession to recommend a solution to the Big Fours' exposure to liabilities threatening their solvency. By the way, Re:Balance is worth reading simply out of appreciation for Jim's elegant writing style. Also, check out his funky bow tie!
"Did anyone really think that the endless chatter about saving the system of privately-provided audits for large global companies would come to anything? …
…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."
I agree with Jim that the current audit model is broken: the notion of independence is fatally flawed, and much of what passes for auditing does not create useful information for investors. Ironically, the "services" that merely provide a perfunctory rubber stamp on management's judgments may create their most significant exposures to liability. Walter Schuetze, former SEC Chief Accountant and FASB member, explained this much better than I can in a 2003 speech to the New York State Society of CPAs. The deafening silence in response to his challenge to make audits simpler and more relevant attests to the fact that political will to fight deeply entrenched interests in the current system is virtually non-existent.
But, I do not agree with Jim's characterization of the Treasury Committee's winding up as an "abdication." Knowing personally and by reputation some of the committee members, like Lynn Turner, Don Nicolaisen and Gary Previts, I would be skeptical that a good faith effort to effect real change was absent. And perhaps, the Committee has unwittingly set the stage for real change by confirming what may have already seemed obvious to many: the absence of economic incentives for the Big Four to compromise.
So, where Jim sees two alternatives, I see a third. If we can all agree that government regulators bear some responsibility for the precarious position of being exposed to a disaster should one of the Big Four goes under – they should have put the kibosh on at least two of the three big mergers when they had the chance – then other solution paths will have been opened. For example, the government could offer to share the litigation exposure from each of the Big Four’s prior audit engagements in exchange for splitting up into two completely separate firms.
The immediate effect of such an offer is that the audit firms will be presented with a "prisoner’s dilemma." They will perforce separately conclude that their best chance of riding out the storm is to cut the ropes that lashed them to the other three lifeboats. If the offer to share costs is generous enough, I’m betting we can have a New Big Eight within a year. While this may not completely obviate the need to reform the audit model, which might take another catastropher to catalyze, at least some progress will have been made.
The cost sharing I am suggesting in exchange for a New Big Eight (apologies to BDO and Grant Thornton) could also reduce litigation costs: legitimate plaintiffs won't be stonewalled because losing a case will no longer result in a firm's demise. And the audit firms would now be able to afford to take claims of less merit to court, thereby discouraging future claims.
There may be other lasting and significant benefits of a New Big Eight as well. First, risks of further litigation could actually be reduced if the new firms act to exercise tighter controls. Second, audit fees could be reduced by competition, with related incentives to innovate and become more efficient.
Would there be any diseconomies of scale from split ups of the Big Four? I don't know, but I surmise nothing drastic would happen. There may be some redundancies in the need to maintain technical staffs, but that could finally provide some real incentives to simplify accounting and auditing rules (maybe that’s wishful thinking). It is also possible that exposure to catastrophic litigation became higher as firms got bigger: operations were simply too decentralized to control effectively, and/or extra-deep pockets gave incentives for plaintiffs to ask for larger amounts of compensation for damages.
I'm already lusting over the prospect of christening the new mini-behemoths. How about PriceWater and HouseCoopers? Would Mr. Young get his first name back on the firm he founded (Arthur, for those of you too young to remember) ? Would the other Ernst be resurrected? Enough already!