Peeling away financial reporting issues one layer at a time

The Big Four: Too Few to Fail

As I wrote a few weeks ago, the most recent display of public handwringing is taking place in Europe over the distinct possibility that one of the Big Four could be forced out of the auditing business. According to a more recent editorial in the Financial Times, four mega firms is copacetic, but three is not. Actually, only four is not OK, because three is definitely not. Jim Peterson constantly reminds us on his blog that the existing four-firm dominance is a systemic financial accident waiting to happen; if things continue the way they are going, it's more a question of when, not if.

We need at least a fifth firm, but preferably lots more, that are capable of taking on the largest corporations as clients. Surely, the public has learned more than they could ever have wanted to know about the concept of moral hazard from the too-big-to-fail banks. And just as surely, the Big Four are too few for financial regulators to let fail. This version of moral hazard is that each of the firms knows the position the financial regulators are in, and they take on more risk as a result.

Saving the Big Four from Themselves

We are in the current pickle in no small part due to the governmental failures to stop at least two of the three big mergers when they had the chance. We can't put that genie back in the bottle, but if accounting firms had incentives to combine, we should also be able to provide them with incentives to divide. In a previous post, I suggested that the U.S. federal government could offer to share certain litigation exposures from any Big Four firm that agrees to split into two completely separate firms on U.S. soil.

Here's another idea. Similar to the 'support fees' that are currently assessed on public companies to fund the operations of the FASB and PCAOB (in proportion to their market capitalization), Congress could create a fund to be used for compensating the partners of Big Four firms that split themselves up. The fund could be doled out on a first-come-first-served basis; or the government could hold auctions; or it could issue a request for proposals and award money based on the attractiveness of the offers.

Nobody is Happy

But, none of these solutions fix the root causes of the problems with the auditing profession. While reading an report in NYT a couple of weeks ago about gasoline engine manufacturers in Japan (perhaps the best in the world) that are struggling mightily to cope with the inexorable market shift toward hybrid and electric vehicles, my one-track mind wandered back to financial reporting: historic cost accounting is to a gasoline engines as current values are to electric vehicles. But, while governments are firmly behind the mass adoption of electric vehicles, the EU, IASB and the U.S. Federal Reserve are actively discouraging financial reports to shareholders that are powered by state-of-the-art measurement (see, for example, IFRS/GAAP) of financial instruments.

The Big Four owe their lock on the largest companies in the world to the complex accounting rules rooted in 1930's concepts. But the sad irony is that nobody is as happy as they could be with the current state of affairs. The public has learned to distrust auditors and to fear a systemic financial crises triggered by the collapse of one of the Big Four. The audit firms have been forced to focus on the least profitable service they offer due to regulatory restrictions on non-audit services designed to maintaining at least some hazy appearance of "independence."

Unlike car engines, auditing will not be modernized by market forces. It will take the actions of financial regulators, like the SEC and the European Commission to protect the public – and the audit firms themselves from the shortsighted interests of their current crop of senior partners. Here is what a sustainable system of financial reporting could look like:

  • A company's board of directors would engage an independent auditor; and separately, independent appraisers to determine the current values of assets and liabilities reported on the balance sheet.
  • Management would prepare income statements, cash flow statements, and roll forwards of all balance sheet accounts.
  • The independent appraiser(s) would provide separate report(s) describing the scope of their work, the extent of their reliance on management for information, and detailed descriptions of the methodologies they employed for estimating values for tangible assets owned by the company, and for the company's contractual rights and obligations.
  • The auditors would perform the following functions:
    • Confirm the physical existence of tangible assets and management's assertions as to the existence of contractual rights and obligations.
    • To the extent required by notes accompanying the financial statements, verify the accuracy of schedules that report past cash flows and contractual future cash flows.
    • Confirm the independence of the appraisers and verify the completeness and accuracy of their work.
    • Verify the completeness and accuracy of management's work.
    • Issue an audit report describing the scope of work, findings (e.g., that the auditor is not aware of any material misstatements), and that they exercised the appropriate level of diligence.

Everybody would be happier. The 'expectations gap' between what an auditor says it does and what it delivers would be eliminated; and since the nature of the audit function would change, the regulators could safely roll back their restrictions on non-audit services. Most important, the stranglehold on large clients by the Big Four would be loosened, because the client would no longer have to depend on the auditor's mastery of disconnected rules that nobody except a few folks in the national offices have a clue about anyway.

Accounting doesn't need to be converged. It needs to be fundamentally reformed so that anyone can audit a big multinational corporation, just so long as they have access to enough people in enough places.

Manufacturers of gasoline-powered engines in Japan can either: (1) change, or (2) lobby their government for international and domestic trade protections. Financial reporting could use a lot more of that first one.



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