Save content
Have you found this content useful? Use the button above to save it to your profile.
AIA

The harder they fall: Will the Big Four survive the credit crunch? By Rob Lewis

by
30th Sep 2008
Save content
Have you found this content useful? Use the button above to save it to your profile.

magnifying glass on a pile of pound coinsRob Lewis wonders whether the events in America will determine the fate of the Big Four.

Ever since Arthur Andersen left the market after its scandalous role in the fall of Enron, people have been asking how long it will be before another big firm follows suit. The Financial Reporting Council (FRC) has been trying ever since to make sure that the Big Four will be protected if found guilty of similar negligence. The introduction of limited liability should help, but given the accelerating meltdown of the global financial system, will it be enough?

As always, and as was the case with Arthur Andersen, it will be events in America that determine the fate of the Big Four. This summer the US Treasury's Advisory Committee of the Auditing Profession met in Washington and heard that that between them the six largest firms had 27 outstanding litigation proceedings against them with damage exposure above $1bn, seven of which exceed $10bn. It is impossible to buy insurance that will cover such catastrophic liability and any one of them, if successful, could prove a fatal blow.

That US Treasury committee met again last week to discuss the viability of limited liability for auditors in the US, but the 21-strong panel decided against it. With that, the hope of some silver bullet solution to the Big Four's problems expired. Committee member Lynn Turner, formerly a chief accountant to the Securities and Exchange Commission (SEC), was plainly baffled such an idea had even been seriously suggested.

"Do you believe that an auditor found to have been aware of financial reporting problems but never reporting them to the public should be the subject of liability caps or some type of litigation reform protecting them?" he asked. Turner summed the situation up nicely when he described the big accounting firms as a "federally mandated and authorised cartel" which was "too big to [be allowed to] fail".

When Arthur Andersen went down six years ago, Turner had never been quite able to believe that the firm's bad behaviour had really been all that anomalous. "It's beyond Andersen," he told CBS Frontline that same year, "it's something that's embedded in the system at this time. This notion that everything is fine in the system just because you can't see it is totally off-base."

The credibility of the markets

Looking at recent economic events, Turner's suspicions that the credibility of the markets were at stake has plainly proved prescient. So too may his belief that unethical accounting was not so much a case of a few bad apples, but a bad barrel.

"It's not that the Big Four are 'too big to fail'. They can fail, and there is nothing on the table to save them."

Jim Petersen, International Herald Tribune

Consider some of the recent and outstanding claims against the biggest six firms. In Miami last August a jury ordered BDO Seiman to pay $521m in damages for its negligence in a Portuguese bank audit; almost as much as the firm's estimated revenue for that year. In the US, banks and the shareholders of banks are perfectly prepared to go after auditors, and when they win they tend to win big. Note than when Her Majesty's Treasury hired the BDO's valuation partner Andrew Caldwell for the controversial Northern Rock valuation, they hired the man and not the firm. The firms are already worried enough about litigation.

KPMG provides a clear example of how the credit crunch might cull the Big Four. The firm was already looking vulnerable before it hit: there was the 2005 'deferred prosecution' agreement with the New York Attorney's Office, the damning German probe into the Siemens bribery scandal, a lawsuit from superconductor company Vitesse for 'audit failures' and a minor fine from the UK's Joint Disciplinary Scheme (JDS) for allowing fraud to occur at Independent Insurance (it may only have been half a million, but it was the JDS' biggest fine to date). But when the subprime problems of US lender New Century enter the picture, the damages involved escalate drastically.

An independent report commissioned by the US Justice Department has already concluded that KPMG either helped perpetrate the fraud at the mortgager or deliberately ignored it. Class-action lawsuits are already pending. Only weeks before the report was published the US Supreme Court's Stone Ridge ruling immunised third party advisers like accountants and bankers from the disgruntled shareholders of other entities, but that may be not much of a shield. Of course, New Century might not be KPMG's biggest problem. That's probably the Federal National Mortgage Association, or Fannie Mae.

Fannie Mae initiated litigation way back in 2006, and is trying to reclaim more than $2bn from its old auditors (the lender has already agreed to pay the SEC $400m). KPMG's defence so far has been one of complete innocence, asserting that Fannie Mae successfully hid all evidence of anything untoward. Now the FBI is investigating the mortgage lender, such a position will have to be abandoned if incriminating evidence turns up. Ostensibly, the Federal investigation relates to Fannie Mae's relationship with ratings agencies, but you never know what will fall out of the closet.

So KPMG is in a spot of bother, but it's not alone. Ernst and Young will almost inevitably see itself in court over the demise of its audit client Lehman Brothers. Similarly, PricewaterhouseCoopers is surely going to feel some heat for its auditing of what was once the world's largest insurance company, AIG, assuming the Northern Rock Shareholders Group doesn't take a pop at it first.

"It's not that the Big Four are 'too big to fail'," as International Herald Tribune Columnist Jim Petersen put it. "They can fail, and there is nothing on the table to save them."

But never mind the Big Four. Some, like Richard Murphy of Tax Research UK or Anthony Hilton of the Evening Standard, have questioned whether audit itself can survive. When our anxieties over the financial markets have eased, it won't just be the experts wondering how useless these statements are. When the Big Four finally shrinks, there will be collateral damage.

Lehman collapse: The story so far

Tags:

Replies (7)

Please login or register to join the discussion.

avatar
By Rob Peddle
08th Oct 2008 08:51

Change - or be replaced!
Dennis,

Unfortunately, you are probably right. If the Audit industry will not change itself when there is SO MUCH evidence around that it needs to, then it will either have to be changed by some other 'governance' mechanism or it will wither and die, replaced by something more relevant to what the users of its output needs.

The commercial World is changing fast, with stakeholder pressure becoming far stronger and companies having to react to this rather than ignore it. It is not only financial probity that they need to deliver, but a raft of economic, social and environmental requirements, all increasing daily. Management’s role will be to decide and deliver a reasonable balance across these issues and be able to demonstrate they have done so to those stakeholders who are impacted. Traditional Audit - of whatever kind - fails to address this by only looking at individual elements of the business, not at it as a whole. Management need to use this broad view to prevent things going wrong and auditors need to use it to check all is OK.

There is therefore a need for companies to operate and manage themselves as a living System, not an agglomeration of activities or sub systems. We call this System Thinking (note the no 's' on System!) and tools and approaches are in the public domain to achieve this - see www.systemthinking.net .

They (and third parties) then need to audit, assess, risk identify - or whatever other term is needed - against how this System operates in real life, not on paper, reviewing the behaviours actually being experienced to identify the real risks inherent in the business. This needs to be consistently carried out in a way that significantly reduces the impact of individual auditors’ prejudices, pressures or whatever else makes them see and report things differently to real life. Using IT solutions with expert system analysis engines provides this consistency and hence confidence in what is actually happening.

We are already changing the Management System World by introducing these ideas and tools into CSR Management System design and Internal and third party auditing. If anyone in the financial and accounting world would like to see how these could be applied to address the current confidence issues, we would be happy to share our experiences – you can contact me through [email protected] .

Thanks (0)
avatar
By jrpllc
04th Oct 2008 23:18

Thanks
Dear Rob -- Thanks for the reference. It's a quote I am very happy to articulate and expand upon.

As Francine knows especially, I've been trying to contribute to this theme for quite a while -- in the International Herald Tribune, for the period I was privileged to be its financial and accountancy columnist, and now on my own -- see Re:Balance -- http://www.jamesrpeterson.com.

Thanks (0)
Dennis Howlett
By dahowlett
02nd Oct 2008 16:46

Bingo!
@rob - at last somebody gets it - well almost. I don't think we'll see 'audit' of the kind you are describing or rather it won't be called by that term. The market rarely if ever takes cognizance of the audit certificate EXCEPT when things go wrong. Ergo - prevent the thing from going wrong.

That means a massive retooling of the industry to understand things that today it is not qualified to express an opinion upon and which are not being taught.

Buying up risk experts is not the answer. There needs to be a fundamental rethink about what information stakeholders need. It is a radical rethink not sticking plaster that's needed.

The problem is that the incumbents cannot see beyond their traditional role. Or if they can, then they have little idea how to handle it.

Thanks (0)
avatar
By Rob Peddle
02nd Oct 2008 10:55

The old Compliance model of audit is dead
Rob and the other contributors are absolutely right - the existing model of auditing is dead. It has been proven to fail in far too many cases. The main reason for its survival is that no alternative has been found - stay with what you know even if it does not work!

The auditing model used in most other 'third party' audits suffers the same problem. Just look at ISO9001 as an example. Even assessment techniques like EFQM are creaking under the surface if you look closely.

So, what is the alternative? Compliance is only part of the picture - it tells you about the past, not risks to the future. Plus there is always the ability to make sure compliance information shown gives the impression that all is OK and the need for the auditor to 'interpret' this into their final report. Current methods are fraught with problems and provide little real confidence in the report. And Confidence is what it is all about!

What matters is a clear and consistent picture of the real risks for the future inherent in the way the company is operating. Real and accurate lead indicators or risk rather than potentially distorted incomplete lag ones based on compliance.

The solution? To identify future risk there is a need to understand the behaviours being exhibited and experienced across the business. These are lead indicators and drive ongoing compliance as well as effectiveness and efficiency. Behaviours of the people within the business indicate whether compliance will continue. Many of the things that drive effectiveness (i.e. delivery of objectives and performance) cannot be documented, and cannot be subjected to compliance checks. It becomes clear that the current auditing model is past its sell by date.

Tools that address this fault with the current audit model are now available. They consistently analyse behaviours and report the levels of risk based on what actually drives ongoing compliance and effectiveness. They can create meaningful and credible benchmarks. More at http://newsweaver.co.uk/cqi/e_article001096736.cfm?x=bcFGKF5,b6HhKKCc .

The auditing world needs to accept that their current model is broken before they will accept the need to change. Fear of not having an alternative stops this admission, but with the development of such tools there is no reason not to admit it. Who will be the first to break ranks? It will be interesting to see ....

Thanks (0)
avatar
By AnonymousUser
01st Oct 2008 11:29

Is this part of the solution?
In my view the Big Four should be eliminated from the audit market.

Here in the UK the problem began in 1990 with the House of Lords Caparo decision. This took away an individual shareholders right to make their business decisions on their firms audited accounts. With this right broken, it was entirely predictable that a companies hired hands aided by an inventive accounting trade, sleaze politicians and captive regulators would create an “age of irresponsibility” to maximise their own short term profit.

As common sense hopefully returns, the sanctioning of those responsible for this situation must become paramount and exemplary to restore public confidence in the auditing process.

A gruesome log of the events leading up to this credit crunch can be seen at :
http://visar.csustan.edu/aaba/aaba.htm

Thanks (0)
avatar
By fmckenna
01st Oct 2008 00:30

It's Not "If" But "When"
It's wonderful to see Accounting Web finally focusing on this issue. Dennis Howlett and I have been writing about it for a while. In fact, the Big 4's bankrupt business model is primary the focus of the blog I've authored for the last two years, re: The Auditors. (www.retheauditors.com)

The litigation, the layoffs, and the lack of professional due care exhibited by the audit firms are just the tip of the iceberg when talking about the Big 4's vulnerabilities. They haven't prevented their clients from failing, warned us adequately of imminent failures, nor helped craft solutions to minimize failures in the future. They are impotent "bagmen," collecting obscene fees while providing a service with no value to investors or anyone else with a stake in global capital markets.

I'm keeping a scorecard of the Big 4 and their increasingly limited universe of clients on my blog. The article, "My Clients Are Failing, My Clients Are Failing," is my way of saying, enough is enough. A new and better solution to safeguarding shareholder and other stakeholder interests is sorely needed.

Thanks (0)
Dennis Howlett
By dahowlett
01st Oct 2008 00:05

Not the first
Rob - you know that Francine McKenna and I have been talking about this for some time.

Check Francine's blog for continued commentary on this. In particular, this piece back in June should be instructive

Check for more corroboration and this piece on EY's future

More to the point, if another of the Big 4 fails then it is the end of audit as we know it.

Thanks (0)