The Auditors and the Elephant

2nd Draft - not citeable - © Robert H. Daniels 12/16/08

Disasters in the capital markets have one very predictable result: more government regulation.

The securities laws and SEC regulations were a response to the Great Depression, while more recently the Dot-Com crash led to passage of the Sarbanes-Oxley Act. With the subprime loan implosion, the ensuing wave of foreclosures, bankruptcies and bank failures, and the extraordinary demands for Federal bailout funds fresh in the public mind, the Obama administration and the 111th Congress will take office next month with a popular mandate: Never Again!

One of the professions likely to face scrutiny will be the auditors, those "gatekeepers" who certify that the financial reports issued by corporate America fairly present the underlying economic reality. The last eighteen months saw the sudden collapse of many apparently solid companies, including the leading subprime lender (New Century Financial), the largest savings bank (Washington Mutual) and two major investment banks (Bear Stearns and Lehman Brothers). In addition, the largest property/casualty insurer (AIG) as well as the mammoth government-sponsored mortgage lenders (Fannie Mae and Freddie Mac) have become wards of the U.S. Treasury as a stopgap move to prevent catastrophic failure. "Where were the auditors?", the public might well wonder. "Why didn't they warn us? What good are watchdogs that do not watch, or guardians who fail to guard?"

These questions are not yet joined to any particular proposals for reform. Before prescribing remedies for a symptom, such as audit failure, one must first diagnose the cause correctly. And if a recent study by a high-level Federal advisory board is any indication, it seems that auditors, corporate managers, investors and regulators alike are still groping blindly towards understanding the problems that now trouble the profession.

The "Advisory Committee Report on the Audit Profession" (which makes for a somewhat rude acronym) was released in October as the work of a blue-ribbon panel selected by Treasury Secretary Paulson from leaders in the financial reporting community. Goldman Sachs, Morgan Stanley and KPMG were among the institutional names gracing the membership roster, which also included former Federal Reserve Chair Paul Volker, former SEC head Arthur Levitt and many others less well known to the general public, but well respected by fellow professionals. The Advisory Committee included Democrats as well as Republicans, Wall Street lawyers and CPAs, bankers and investors, a chief finance officer and a labor union leader, a distinguished professor and the president of the leading professional society for accountants. The Committee, assisted by Treasury Department staff, met nine times in the course of a year, heard 57 witnesses, received 101 written submissions, and went through two rounds of drafts to generate the 219-page (with Appendices) Report.

The result was disappointing. The views of the various members seem to have cancelled each other out. Their collective wisdom did not compound, but instead shrank down towards a common denominator. The recommendations are a mixture of platitudes ("Implement market-driven, dynamic curricula and content for accounting students that continuously evolve...bla..bla...bla." p. VI-2), sensible minor improvements such as a National Center for sharing information on fraud prevention (p. VII-1), calls for further study ("to analyze, explore, and enable, as appropriate", p. VII-8) and the harmless wish that co-operation among regulatory agencies can be "encouraged" and "enhanced", while leaving the audit profession itself pretty much unchanged. (pp. VII-3 and VIII-20.)

These proposals are inconsequential when compared to the losses from recent financial reporting failures. New Century, for example, overstated earnings by 129% in its last quarterly report before the bankruptcy filing (Bankruptcy Examiner's Report, p. 384) and AIG's top executives had assured investors that it was hard to see how the company -- now kept afloat by $80 billion in US Treasury funds -- could lose a single dollar on its credit default swaps.

When it came to the important issues, the Committee was an outright flop -- a very public failure. The Report's "Background" chapter explains why recent changes in the market for corporate audit work have caused concern: four giant firms now handle 98% of the audit work for major US companies, the private partnership structure of those firms veils their inner workings, a single botched audit could result in legal liability for damages so large as to destroy any one of those firms, and the collapse of an audit firm could trigger a general breakdown in financial markets. The ghost of Arthur Andersen & Co. still haunts the profession, and the Committee froze when confronted by the specter. There was no consensus on a solution, only a diplomatic reference to "a failure to find common ground" on "the role of the civil litigation system in relation to public company audits." (p. II-6). In a rare display of disharmony, one committee member, a former Chief Accountant at the SEC, even filed a written dissent.

The online transcripts of the committee meetings hint at what went wrong. The problem, it seems, was "Elephants" -- big issues so potentially disruptive to the harmonious work of the group that everyone had to pretend to ignore them. They first appeared at the March 13 2008 meeting, when Paul Volker spotted an audit firm finance elephant and a service line conflict elephant. Lynn Turner (former SEC chief accountant) then expressed his dismay over the failure to deal with the audit independence elephant. He was seconded by Damon Silver (AFL-CIO), who added oligopoly price gouging to the list of big issues issues that the Committee would prefer to discretely avoid.

The elephant parade continued at the May 5 meeting, when Co-Chair Levitt faulted his colleagues for giving too little attention to the public image of auditors, and the metaphor was subsequently picked up by William Travis (McGladrey & Pullen) to criticize the panel's failure to agree on a solution to litigation risk:

"Because, to simply say the elephant is in the room and we can't agree on whether it's an elephant or a really large rhinoceros makes no sense."

Richard Murray (Swiss Re) concurred, voicing doubt as to the effectiveness of a proposed backup plan to rehabilitate any firm that faced collapse due to litigation or similar risks
So many Elephants! What deep subconscious impulse can possibly produce such a fixation on pachyderms, large and small, "in the room" or absent? Perhaps the committee members share a childhood memory in common, a remembrance of the fable, first told in ancient India, about six blind men who try to describe an elephant by touch:

"The blind man who feels a leg says the elephant is like a pillar; the one who feels the tail says the elephant is like a rope; the one who feels the trunk says the elephant is like a tree branch; the one who feels the ear says the elephant is like a hand fan; the one who feels the belly says the elephant is like a wall; and the one who feels the tusk says the elephant is like a solid pipe."

Just so, it seems that for the audit profession:

The elephant is lawsuit liability

The elephant is concentration and oligopoly

The elephant is loss of independence

The elephant is firms structured as partnerships

The elephant is lack of firm transparency

The elephant is the need for 'human capital'

The elephant is audit quality

The elephant is too many technical rules.

Step back. Open your eyes and look again. The elephant is all of these, for they are interlocking facets of the problem facing the firms and those who work in them. Audit is a 21st century profession stuck in a role model that is one hundred years obsolete.