Auditor Liability Reform – Same Old Same Old

SOSO

Is it a co-winky-dink or is it just me? Today we find the Wall Street Journal drooling like a puppy in a feature interview with Dennis Nally of PwC US just a few weeks after KPMG received some very pleasurable coverage of how they’ve fixed all of their tax problems after the WSJ delayed some bad news for them as long as possible. Today we also have Letters to the Editor of FT from KPMG UK and Grant Thornton UK/BDO UK in the Financial Times. These writers were responding to some hard questions by the FT’s Lex editors:

“But it remains unclear why auditors should require special protection denied to other professions. Even a study funded by the Commission found little hard evidence that European litigation presented a credible threat to the survival of the remaining auditing giants – or that the best way to restore investor confidence in the aftermath of a big scandal would be to let the auditing firms involved keep on doing business as usual.”

It’s a public relations steamroller, baby the likes of which we haven’t seen since the last time the auditors felt threatened. As I discussed in my post about the Center for Audit Quality, the new US lobbying organization for the audit industry, we’re going to start seeing the same phrases over and over again when the auditors are talking about the liability issue, the responsibilty of the auditors to find fraud, the transparency issue and questions about why they didn’t see problems like stock option backdating coming.

But if the auditors want liability reform, they should be willing to open the books, wide open, more than Dennis Nally does below for PwC US, including owning up to the extent of (and funding sources for) their reserves for pending litigation, just like the public companies they audit are required to do.

So, for example, from the Deloitte 2006 Annual Report:

“…auditors are increasingly subject to immediate regulatory action and civil litigation whenever fraud is exposed in public companies—including systemic collusive fraud by management —a phenomenon that the audit was never designed to guarantee against…”

“…That effectively places audit firms in the position of insurers of the capital markets, which is an unsustainable position…”

“…Each Deloitte member firm is required to purchase professional liability insurance …at a level that is believed to be appropriate for the risks associated with the services it provides. Notwithstanding, such insurance protection is far less than the potential exposure to claims against the profession…”

“…Deloitte member firms, like the others, are private partnerships, …increases the personal liability for the owners. …may also …have an impact on the long-term viability of professional services…”

Now let’s look at some selections from the interview with Nally in the WSJ (for an alternative to the “party line” take a look at my links):

Accounting’s Crisis Killer
Tumult Eases for PwC’s Nally;
Does He Do His Own Taxes?

“When Dennis Nally took over PricewaterhouseCoopers LLP in the U.S. in 2002, the accounting world was reeling from a series of corporate scandals and the demise of Arthur Andersen LLP. The remaining Big Four accounting firms soon faced new rules, a new regulator and an investing public that had lost some confidence in auditors.

Today, the sense of crisis has diminished. Market-shaking corporate meltdowns have been on the wane. The Big Four — PwC, Deloitte & Touche LLP, Ernst & Young LLP and KPMG LLP — have adjusted to their new, regulated environment. And they have actually seen business boom thanks to work heaped on them by new rules meant to clean up a mess that some critics say they helped create…

With the firms today on surer footing, Mr. Nally now finds himself dealing with numerous nettlesome long-term issues, which he discussed during an interview in his firm’s New York headquarters. Fearing potentially catastrophic litigation, he argued that firms should get special protection from lawsuits. Mr. Nally also said the public needs to better understand auditors’ responsibility when it comes to catching fraud. And he expressed willingness to consider publishing accounting firms’ financial results, something these private partnerships don’t now do. In a nod to this possibly increased transparency, Mr. Nally disclosed details about PwC’s profits. No other Big Four firm has ever publicly disclosed such figures; in fact, the firms until recently even balked at disclosing revenue figures for their U.S. arms.
…
WSJ: Do you see a need for increasing competition beyond the Big Four?

Mr. Nally: I don’t think we have an issue. There’s a tremendous amount of competition among the four firms today. It’s important to go back to why the firms came together the way they did. That’s all about trying to create the scale, the critical mass to serve some of the largest companies in the world.

Bloggger Note: PwC, in general, and the US firms, specifically, are alone in this view. Everyone else is studying the issue and fed up with lack of choice.

WSJ: Why are the firms pushing for a limitation on liability for auditing public companies?

Mr. Nally: There is a concern that without some form of liability relief over time you run the risk that one of these firms ultimately fails, there is a catastrophic loss that can’t be dealt with. Every one of these firms is a partnership and having the ability to sustain this profession over time is making sure that the liability question is addressed.

PwC’s disclosure about profit marks a first for one of the U.S. arms of a Big Four accounting firm. In revealing the figure, Mr. Nally said his firm would be open to the idea of publishing financial statements if that was included in an overall agreement aimed at curtailing audit firms’ litigation risks. Read more from his interview with The Wall Street Journal.

WSJ: In your fiscal year that ended last June, PwC in the U.S. generated nearly $7 billion in revenue. How much of that was profit that could be distributed to your firm’s 2,069 partners?

Mr. Nally: Between $1 billion and $1.4 billion.

WSJ: It’s tough to assess the risk facing the firms because as private partnerships there’s no financial information available. At what point do the firms have to say here are our financial statements, just like public companies do?

Mr. Nally: I would think, dependent upon where all of this conversation goes, if there is to be some form of [liability] relief there obviously would have to be more transparency around that.

WSJ: Is it an auditor’s job to try and find fraud?

Mr. Nally: Absolutely. We have a responsibility to perform procedures that are detecting fraud just like we have responsibilities to perform procedures to detect errors in financial statements.

WSJ: You seem pretty certain, but the firms as a whole often eschew some responsibility for finding fraud, especially in court.

Mr. Nally: The audit profession has always had a responsibility for the detection of fraud. The debate has always gone toward how far do you carry that, what type of procedures do you have to develop and in what environment. The classic issue becomes the cost benefit of all of that and this is why I think there is this expectation gap.

WSJ: There are more than 140 companies under investigation over backdating of stock options. As was the case with the Enron and WorldCom debacles, that has given rise to the question: Where were the auditors?

Mr. Nally: If the public has a view that the auditor’s report on a set of financial statements is designed to provide absolute assurance, that is not what the auditing profession and the [auditing] literature requires today. We’re providing reasonable assurance. There’s a big difference between absolute and reasonable.
…
WSJ: Last year, due to problems related to the quality of audit work at PwC’s affiliate in Japan, PwC was forced to start a second firm there. The original affiliate recently announced it was closing, leaving PwC with a very small presence in this key market. How does that impact the global PwC brand and the U.S. firm?

Mr. Nally: Japan is a great example of the need to look at our network and how to make sure that we have the ability to deliver a consistent level of quality services everywhere we’re doing business.

WSJ: How could things have gotten so bad under the firm’s watch that PwC would have had to cut its affiliate in Japan loose?

Mr. Nally: It goes back to having a clear understanding of what is required in different parts of the world around auditing standards, the culture around the auditing profession. And it’s important to have that degree of understanding in terms of what actually occurred in Japan. The environment in Japan has historically been very different from the environment, from an auditing standpoint, in the Western world. There’s a move afoot by the Japanese regulators to make changes into that marketplace, which we fully support and encourage, and that’s part of this as well.

WSJ: Like the other firms, PwC has supported the Sarbanes-Oxley law and the controversial rules that require auditors to sign off on companies’ control systems for preventing accounting mistakes and fraud. Some critics have said this is because you’ve used the fees generated by the law to offset revenue lost due to another post-Enron rule that barred accounting firms from selling consulting services to audit clients.

Mr. Nally: Obviously I’ve heard that, and I have to doubt that it’s the case. When [the rule] was issued, I think PwC and the other firms tried to apply the standard as best as they could. And the new standard was issued very quickly and not surprisingly created a lot of angst and stress in the system. I think there was a real attempt to apply that standard in the best way possible and that’s what PwC did.

WSJ: Do you think small companies with stock-market values of less than $75 million should be subject to checks on their internal controls or exempted as some have called for?

Mr. Nally: There ought to be a consistent approach whether a large company or a small company. If the argument is that the standards will result in a process that is just not cost efficient for these smaller companies, we ought to just [exempt] those companies and let the investors know that. But I don’t think that we ought to have two types of standards.”

Now let’s look at the Letters to the FT Editors:

Why sector needs special protection
By John Griffith-Jones

Sir, In examining the proposed new rules governing auditor liability in Europe, Lex (March 19) questions why the audit profession should “require special protection denied to other professions”.

The reasons have been openly debated at length. They come down to the simple but unpalatable fact that the “Big Four” do not have the financial strength or insurance cover to meet the size of claims that could potentially arise from an audit failure at a major international company.

Without a globally agreed liability regime, the world’s capital markets continue to play statistical Russian roulette with the Big Four. This, I can assure you, continues to provide more than enough “incentives for diligent auditing” but is not, in our opinion, a particularly sensible way forward for Europe; better instead to allow Charlie McCreevy, the internal market commissioner, to consider his deliberations.

John Griffith-Jones,
Chairman,
KPMG LLP,
London EC4Y 8BB

Criticism of McCreevy over audit reform is unfair
By Michael Cleary and Jeremy Newman

Sir, Our two accountancy firms have emerged as the challengers to the “Big Four” as capital markets around the world have called for greater choice in the public company audit market. We feel it necessary, therefore, to comment on Lex’s unfair criticism levelled at Charlie McCreevy, European commissioner for the internal market (“Auditor liability”, March 19).

There is a pressing need for appropriate auditor liability reform. Auditors play a critical role in maintaining capital market confidence. The current system of joint and several unlimited liability is simply not sustainable if a robust audit profession is to survive. It means holding an audit firm to account for the totality of a corporate collapse, regardless of the degree to which its audit is found wanting. If any of Europe’s largest companies were to fail, claims against their auditors could reach tens or even hundreds of billions of pounds.

Audit firms should not and cannot be expected to act as insurer of last resort for such claims. The current system opens the capital markets to the risks of a sudden, catastrophic loss of a major audit firm, with the consequential damage that would do to capital market confidence.

Mr McCreevy should be applauded for initiating the debate on liability reform in a calm atmosphere rather than in the fevered atmosphere that inevitably follows a corporate collapse. He is not, as Lex puts it, more concerned with protecting former colleagues than investors but recognises the critical role played by auditors and understands that investors as much as anyone need a healthy, robust and sustainable audit profession. He has also recognised the need, eventually, for a global liability regime, towards which the European Union’s consultation is a significant step. We understand the suspicion that falls in particular upon the Big Four in any debate on liability reform. Our two firms have over many years argued consistently in favour of appropriate, rather than any, reform of auditor liability, the key principles being:

*reform must be, and must be seen to be, in the public interest.
*audit firms should be held accountable for their fairshare of a corporate failure.
*audit firms should not be protected from their own systemic failings.
*no audit firm should be considered too big to fail.

…It is a myth that quality is driven by unlimited liability.

Auditors must be held to account for their actions, but destroying a whole audit network because of shortcomings of others is not the way to ensure confidence in the capital markets in the decades ahead.

Michael Cleary,
Managing Partner,
Grant Thornton UK LLP

Jeremy Newman,
Managing Partner,
BDO Stoy Hayward LLP