How Will We Solve The Financial Crisis? The Answer Is Bigger Than You And I

I read two interesting articles this weekend, amongst many others and lots of Twitter conversations about the inauguration festivities and the financial crisis. One was a wonderful summary by Jonathan Weil at Bloomberg on the role of the Big 4 auditors in the death of the financial organizations.

At least, it was a call to the Big 4 to start doing their job:

“Here’s hoping the big audit firms get busy living, and start sounding alarms at banks that are dying.”

Joanathan and I have exchanged emails and shared insights. I’m so glad he has listened to my whispering in his ear and wrote the article he had in him the whole time he was writing about individual cases. One of the problems I have had in getting attention to this issue is that there are so many other fish to fry – the companies themselves, the ratings agencies, individual executives. It seemed until recently that it was gloves off and the Big 4 was getting a pass.

Until Madoff and Satyam.

“The public’s patience may be running out. One sure sign is that investors are starting to blame big accounting firms for frauds at places they never even audited. There’s been no indication that PwC or KPMG, for instance, should have known Bernard Madoff was running a Ponzi scheme when they blessed the books of other funds that sent him money. The firms are getting impugned anyway, even though Madoff’s auditor was someone else.

Then there are the scandals where the firms have lots of explaining to do. Last week, PwC’s India affiliate issued a statement about its work for Satyam Computer Services Ltd., which overstated its cash by $1 billion. The firm said its audits were conducted “in accordance with applicable auditing standards and were supported by appropriate audit evidence.” ”

We’re starting to see a flood of statements similar to the one above by PwC regarding Satyam. Wait! That’s what PwC said when they pulled their audits at Yukos. And that’s what EY is saying as it begins to distance itself from its prior audit opinions at Anglo Irish Bank.

“Ernst and Young confirms that all of the audits conducted for Anglo Irish Bank shareholders were undertaken in accordance with the appropriate auditing standards.

Ernst and Young is confident of all audit opinions expressed to Anglo Irish Bank shareholders in the bank’s financial statements and that the accounts show a true and fair view of the state of affairs and results of the bank in accordance with the information and explanations received.”

So, you may finally be saying to yourself: What’s the point of audits and auditors?

The other article I read this weekend was by Felix Salmon in Portfolio and was a response to a Joe Nocera article about the “bad bank” solution which skirted the nationalization issue.
“We can’t do something like that today: the world has changed too much for insolvent banks to be able to hold toxic assets on their balance sheet at overinflated values and operate indefinitely as a going concern. Bankers who rail against mark-to-market accounting are essentially indulging in nostalgia for the 1980s — but we can’t go back there. Instead, the insolvent bank has to be nationalized. Eventually it will go public again, either with the bad assets excised from its balance sheet and moved to some other arm of the federal government, or else after those bad assets have recovered in value enough for the bank to be worth a positive amount of money….”

Well, given that the investments by central banks and government institutions both here and in the Europe are nationalizations of financial institutions by any reasonable definition, the question is timely. Who should be auditing nationalized institutions, especially when the current auditors of those institutions may be culpable and are under the pall of litigation as a result?
In the UK, there are cases such as Northern Rock. Here in the United States, we have resisted calling the virtual takeovers, overgenerous subsidies with few strings, and outright propping up by purchasing majority stakes in entities such as AIG, Fannie Mae and Freddie Mac a nationalization.

Why? Stubborn pride. But, more importantly, a desire to leave everything as status quo, including replacing management with more corporate executives from the same cliques, leaving incompetent Boards of Directors intact, including their inept audit committees, and not firing the Big 4 auditors. (I’m still waiting for the announcement of the new Board for Fannie Mae and Freddie Mac which decides on whether to continue with PwC and Deloitte as their auditors.  Not!)
The Federal Reserve Bank hired a former Bear Stearns risk management executive.

The FSA, the UK regulator, hired a former EY partner from the firm that audited Anglo Irish to advise it on how to address their banking crisis.

PwC is still auditing AIG and Freddie Mac. Deloitte is still auditing Fannie Mae and now another nationalization due to significant losses, RBS.

“Royal Bank of Scotland (RBS.L) unveiled the biggest loss in British corporate history on Monday, overshadowing a second government bailout for the sector and sending its shares reeling to a 23-year low. RBS said it would report a 2008 loss of up to 28 billion pounds ($41 billion), driven largely by a goodwill impairment charge of 15 to 20 billion pounds related to its acquisition of parts of Dutch rival ABN AMRO in 2007. Excluding goodwill impairment, the bank said in a statement it expects a full-year loss of 7 to 8 billion pounds.

The statement came as the UK government sought to counter a looming recession by unveiling a new rescue package for banks that will see its stake in RBS rise to nearly 70 percent from 58 percent.

Why are we pretending that a Big 4 firm is independent and objective when continuing to audit an institution that failed under their watch, one that may be dragging them into litigation, one in which they have failed in their duties to protect the shareholders? And the only experts the government seems to be able to find to clean up the mess that happened on the Big 4’s watch are the Big 4?

Let’s tear down the walls and rethink how we should protect the investor, who in many cases is now the taxpayer. Get rid of the for-profit audit firms involvement in the nationalized entities and those receiving government bailout funds and draft all able bodied audit and accounting professionals into the National Service Corp for Accountability and Transparency. TM

How will the current audit firms meet their responsibilities and obligations to the taxpayer when, in service to their partners desire to maintain partner profits in what they see as a downturn, they are cutting professionals from their ranks and reducing them to four-day work weeks?

The GAO, with the support of the PCAOB under a newly restructured SEC that focuses on examinations and enforcement rather than public relations, should be hiring every auditor and accountant they can lay their hands on and putting them to work on the nationalized entities directly. They can audit on a government standards basis (It’s tougher than public standards!) and set up new policies, procedures and processes to provide improved controls and monitoring of the nationalized banks, the Big 3 automakers and financial firms such as AIGand GMAC. It’s a “once in a lifetime opportunity” both to revamp the capitalist process in service to all stakeholders and to provide jobs to well qualified professionals.

And what will the Big 4 do in the meantime? Well, they certainly should not be wasting everyone’s time and money trying to be systems integrators. They’re not that good at it, the market is not going to be moving for a while, and they can’t compete and offer best in class services under the audit firm mantle. Not when their market share is immediately sliced down due to independence considerations.

Audit firms should be only audit firms, and now even less so. Tax, M&A, investigations work? All go into separate firms that have only the normal conflict restrictions and can operate as small partnerships of like minded partners with similar values and goals. The way it’s supposed to be.

The government can hire the audit firms like a “staff augmentation firm” for audits of the rest of the public companies. The firms can be “drafted” and work on what the government tells them to work on under government employee supervision, on a “martial law” type basis. After all, it is a crisis of proportions not seen since the Great Depression!

The public companies, what’s left of them, can pay a fee like banks do to the FDIC/Federal Reserve now for exams. The audit firms should have no direct profit motive and no relationship with the companies or their executives. They will work for the government and have no legal further responsibility for the audits. (That’s one thing that should make the Big 4 happy.) The audits will performed by the government with a new National Service Corp for Accountability and Transparency TM and additional remaining audit firm loaned staff.
More details to come, but I think it’s about time to quit the charade of the Big 4 being encouraged to stick their fingers in the pie and allowed to pull out the fattest plums, no matter how dirty their hands.
29 replies
  1. Anonymous
    Anonymous says:

    I understand your frustration with the current environment (and I share it). I think I understand your recommendation, and I generally support it.

    My single cavil is whether the Feds can run an effective audit group such as NSCAT. While David Walker (former Andersen partner) was generally lauded for his leadership at GAO, it’s not clear to me that GAO can perform effective audits under GAGAS. As far as I can tell, GAO has basically just performed reviews of other (Big 4) firms’ audits. E.g., RAND, JPL, etc. Can GAO “man up” to the task?

    DCAA (the audit group for Dept. of Defense contracts) has recently come under fire, sparked by a July 2008 GAO audit report (not performed to GAGAS standards) that alleged independence violations, GAGAS failures, and audit conclusions unsupported by evidence. Not a pretty picture.

    PCAOB and SEC have also been almost entirely ineffectual at auditing the auditors and ensuring the audit quality of public company audits.

    In summary, I’m not confident that the Feds can manage your NSCAT concept — though I do support the thrust of where you’re going.

    — Tenacous T.

  2. Francine McKenna
    Francine McKenna says:

    @Edith Orenstein Yes, I am recommending nationalization of the audit efforts for all firms under tarp and majority owned or with significant investments from the US taxpayer. Multinational companies would be audited just like any US government agency or department with overseas operations and administration is audited, by a local team led by government employees and staffed by professionals under contract or by a traveling team of government employees.

  3. Anonymous
    Anonymous says:

    To Anon at 02:54,
    It is a very grammatical headline. It should be “I” as it is assuming you finish the sentence with a preposition…e.g., bigger than I “am/is/are/was/were” — Me would actually be making it incorrect…

    While I don’t agree with Ms. McKenna’s conclusions, I will have to point out that she does have appropriate grammatical skills.

    Find it funny that you felt the need to “point” the nit-pick out…albeit wrong!

  4. Independent Accountant
    Independent Accountant says:

    I oppose nationalisation of audits. Why? The nationalized audit agency will he hopelessly politically compromised from the start. Look at the SEC. It’s a mess. Why will the Feds, who have a compromised FDA, DOJ, SEC, FTC, etc., be any better here?
    Tenacious: The Federal audit agency will be as transparent as Zimbabwe Ben’s operation, i.e., not at all.

  5. Anonymous
    Anonymous says:

    Boy do I hate grammar Nazis, but here we go:

    The headline is grammatically incorrect. Because “I” is the subject, the subject form should have been used- “me”. The only exception to this rule would be if the subject refers back to the subject – “It”, as in “It was she”. That’s not the case here.

    The proper sentence would be “The answer is bigger than you and me”.

    Can we talk about auditing now?

  6. Anonymous
    Anonymous says:

    Francine, even I agree with many of your points above, I don’t think nationalization of the audit efforts is the answer. The government itself has too many problems already and we don’t expect it will make the audit firms better. The root problem of the current system is that the audit firms are paid by the management, therefore, there is no true independence or objectivity. Honestly, for those who work/worked for the big 4, how many times you have been “hinted” by partners to downplay your findings. To address the root cause, I want to share some of my thoughts:

    1) Like what Francine said, the audit firms should never be allowed to perform any work other than audit/attestation related work. No consulting, no tax, no M&A… Currently the firms have their own independent policies. However, there are many grey areas which leave too much room for their own interpretations. The new rule should make a clean cut – audit firm should do audit only.
    2) The big 4 should be broken into a number of smaller firms either by group/functions (audit, tax, etc), or other criteria (maybe E&Y should become Ernest, and Yong – two companies). I want to stress that I don’t mean that there are not enough competition out there. I mean that the current competition environment is not healthy. I can spend whole day here to talk about the competitiveness of this industry, but the key point is that to certain extent, company managements do not have adequate information (expertise, pricing etc…) to pick their auditors. They THINK their option is limited. So, if PWc and E&Y screwed up, they could only go for D&T or KPMG… You see that happened every day. There is a huge information gap between big 4 and the second tier firms. So breaking up big 4s and plus my suggested rating system (stated below) will improve the competition environment, and benefit the employees (more companies, better paid).
    3) Implement a mandatory rotation system. One audit firm cannot perform audit on a public company for more than 3-5 years. I remember this idea was brought up and discussed after Enron before SOX period, but it got killed by the lobbyists. One of the arguments was that it would hurt the learning curve. But given the employee turnover within big 4s, how many times they would have same staff on the same engagement for more than 3 years?
    4) Make the PCAOB inspection report 100% public. I understand that currently only certain parts of report are made public, and the details of inspection findings are only issued to the inspected firms only. In addition, I think PCAOB should implement a rating system for all the CPA firms. The rating system should be designed and evaluated based on the quality of audits performed by each audit firm (from PCAOB’s own impaction result and sampled feedbacks from public companies), and should be renewed or re-evaluated on a yearly basis. In this cases, it provides a guideline when companies pick their auditors. Thus, the audit firm will only be rewarded by focusing on quality of audits.

    Again, some of the ideas are not new. But I think we should reconsider these options.

  7. Anonymous
    Anonymous says:

    Currently the market will have lots of auditors looking for work given the 4 day work weeks suggested by some of the big 4s

    I personally would love to work for the government- I hate the “sales and sucking up” part of the audit, I just want to do my job, but its all about the wining and dining of the client and trying to sell more services and persuade ourselves that a material weakness is a SAD and a SAD is well not a SAD after all- I HATE THAT!

    The PCAOB has high calibre staff, I believe that this dept should be used to do the govt audits- this is the urgency and need and the people there are smart and the non-govt funded companies should still have audits inspected on a periodic basis…..just right now the focus should be on looking out for the tax payers money!

  8. Anonymous
    Anonymous says:

    just want to check on you and your friend Jonathan. You do realize it isn't the auditors responsibility to ensure the company turns a profit, right? Audits don't ensure business success. That is why no one is blaming the audit firms for these failures – the businesses failed, it happens everyday. The auditors are there to make sure the company is telling you it failed.

    So lehman brothers failed. How is that possibly E&Y's fault? Jonathan says if citibank reports another crazy balance sheet, it will be the end of KPMG. How does that even make sense? If it is a screwed up company, it is going to have a bad balance sheet. KPMG has nothing to do with that.

    People aren't jumping on the audit firms for the financial collapse because the audit firms aren't to blame (Madoff and Satyam are clearly differnt).

    Audits don't guarantee positive economic returns.

    On an aside, if you question audit quality now, wait until you have a government in charge of it. Woah. Talk about professionals fleeing the scene. How in the world would a government organization attract the type of talent needed to carry out a complex audit? Not to mention the required valuation expertise.

    Take a look at the TARP. The government can't. It outsourced everything to professional firms.

  9. Anonymous
    Anonymous says:

    The cost for a company to receive an audit from the NSCAT would have to be significantly lower than what current audit fees are for this to work. Otherwise, those Companies will simply list in the UK, Europe, etc, and then hire the big 4 overseas (who will refer the work back to the Big 4 in the US). They may even see a drop in their audit fee since depending on where they list they may get out of complying with SOX.

    My gut feeling is that the NSCAT would not be significantly lower. Even though you can say the entire portion of an audit fee which was profit under a private model will be removed, there would undoubtably be more staff and managers on each engagement taking a longer time to do a more thorough job, which would wipe out any savings.

  10. Richard
    Richard says:


    I assure you we in the UK are seeking to tackle the same issues

    I don’t think we’ll be a cheap date for much longer

    You might have noticed that we too suffer at the hands of the Big 4

    Richard Murphy

  11. Independent Accountant
    Independent Accountant says:

    Anonymous of 11:50:
    I am in partial agreeement with you. The Justice Department (DOJ) has a tool called the Herfindahl Index (HI). When an industry's HI exceeds 1,800, the DOJ looks to break up some of its larger players. About five years ago I calculated the HI for the CPA industry auditing SEC registrants: 3,700! I would break the Big Four into 16 smaller firms.
    I would prohibit a CPA firm which audits SEC registrants from providing other services to the SEC registrants. For example, PWC audits Exxon. I would let PWC offer tax services to General Motors, a D&T audit client and so forth. I see no benefit to auditor rotation or PCAOB inspection. My experience with the PCAOB is that its people are incompetent at best; Big 87654 stooges at worst. I would end peer review too!

  12. Chicago Accountant
    Chicago Accountant says:

    I have no qualms with serving my country. I would like to work for a regulator for a while to do my “tour”. However, the day audits are nationalized is the day I would leave auditing.

    I think audits by the federal government would mean lower pay and lower quality. Could the profession attract young talent when the federal government is the only one hiring?

    I find the rating idea interesting. However, you would need more than one rating system. Every rating is imperfect. How many sports ratings are out there? How many college rankings are out there? The list keeps going. Rating systems are tough to create and always miss the mark.

  13. Anonymous
    Anonymous says:

    Independent Accountant,

    I like Fran’s suggestion that audit firms should specialize in audits and stop trying to be consultants. That would creat significant downsizing (perhaps on the order of 50%) as the firms shed expertise and people that are not integral to performing quality audits. Tax expertise is obviously necessary to support audits but tax return preparation should be part of the divested expertise.

    In its desperate last days, Andersen proposed doing something much like this, under the proposed leadership of Buddy Volker. But by then, it was too late for them. It would be interesting to see how the experiment would work in the current environment.

    P.S. to Independent Accountant — If you think the NSCAT audits would not be transparent, I would ask what you would be comparing them to? Do you think the current Big 4 audits are transparent? Actually, could the current environment be any less transparent? I don’t see how NSCAT would be any worse than what we have now.

    Fran, I would also consider the following as a transition step toward the NSCAT end-state:

    Eliminate competition for audits based on price. Have SEC or PCAOB establish fixed or fixed narrow band pricing for audits based on estimated scope and budgeted hours. Have each firm charge the same fees for the same audit scope. That would force quality/past performance to become a more important selection factor.

    The fact is that the Big 4 pay roughly the same salaries and fringes for similar experience levels. Thus, partner compensation and other overhead factors are the large cost drivers. So setting a narrow band for audit fees tied to scope is entirely feasible.

    However, cost drivers are dwarfed by pricing pressures. Everybody bids low for the first couple of years, runs at a loss, and then jacks up the fees in the outyears. The need to make a profit in the “for-profit” audit world puts undue pressure on audit hours and quality. I would eliminate that pressure as soon as possible.

    — Tenacious T.

  14. Anonymous
    Anonymous says:

    This is a very naive and simple way at looking at things. As someone mentioned before what has primarily happened in the states and globally is structural business issues and the deregulation of limits that had been in place for 70 years that allowed businesses to break through old limits on the amount of risk they could take. We slowly over time pulled away at the supporting beams of our economy that limited excessive risk taking, all in the hubris of consumers will always spend/borrow more and real estate will always go up. This generated hyper accelerated returns and then created hyper accelerated losses. In addition congress pushed Fannie/Freddie and banks in general to loan to those who in reality should not have gotten a mortgage. To limit this risk and exposure banks securitized these loans and sold them off, transferring the risk away from them to others in the market. Like a virus this spread throughout the investment world and infected mutual funds, corporate cash holdings and retirement plans. When the merry go round started to slow down, people were left holding the bag as the ability to roll these securitized assets dried up. People stop lending and the gears of the economy stopped abruptly.

    We are in unprecedented times where no one knows which direction the market will take. In October we saw huge swings in equity markets and complete lockdown of fixed income. We saw scenarios that if suggested just 6-12 months prior no one would have lent a iota of credence to. To lay that blame at the feet of the auditors who only role is to opine on the historical balances and known, reasonable future outcomes is absurd. Regulators, analysts, business people, all did not see this coming and all had wild and varying opinions on what to do, which by the way have all turned out to be wrong to one degree or another. After all wasn’t it politicians and academics that postulated the theory of too big to fail when they lifted such regulation as Glass/Steagal.

    It is laughable this idea of governmental audits and the poster above noting that it will simply gravitate to lower regulated markets is 100% correct. And believe me you will not get anywhere near the qualified people to go work for this agency. Current regulators already have to deal with flight to quality issues as it is.

    You post all this negative on audit firms and lay all the blame at their feet and yes there are clearly failures and some are egregious. I would challenge you to find any industry or profession that has a 100% clean track record. People do not understand that all the regulators and politicians and auditors will never alleviate all the risk in the market of bad business decisions, sudden unforeseen market events or just plain old criminal activity. BUT you can bet they limit it or make people think twice about it. Audit firms accomplish much simply by threat of their existence and I have been in the rooms where partners make the tough calls or continuance and restatements and difficult discussions with clients. The only things that get noted in the papers are the failures, never the success stories. What will your nationalized auditing firm do when it has its own string of audit failures because you can bet it will, either through fraud or negligence. No government regulator has a history of always getting it right and this would not break precedent. It would simply replace the current concerns with a whole other set of issues.

    We have lived through unprecedented economic growth really going back to the 80s. To sustain that growth we have relaxed limits on corporate regulation and personnel borrowings. At some point that bill had to come due and it did. We as a society should have seen this coming, it was common sense. We should have done something to brake this and limit the risk companies could take on to fuel growth but we didn’t. So now here we sit 90 days past due and with the sheriff at the door.

  15. Oversight for the Better
    Oversight for the Better says:

    Lots of good comments from everyone. However, I want to object to the assumption that all government employees are inferior. There are plenty of intelligent, well qualified , hard working people employed by our government. I held a position with the Dept. of the Treasury once and worked to the same standards as I do in private industry.

    As with any organization, effectiveness depends on good management and leadership. The previous administration had such a hatred of government that they purposely appointed poor leaders and mismanaged with glee.

    Back to the blog – Is anyone going to lead this discussion under the new administration? If not, is anyone who reads this blog interested in getting it started?

  16. Kim
    Kim says:

    K … nice all … who is going to pay these people and how much? Should it be a charity event? R U going to engage youth with “public service” (read … no money).

    Sorry … I’ve never been big 8 (oops … showed my age). We have a nice audit practice, once again. The big 4 and the big regionals evacuated the small yellow book and npts. The sole pracs bailed after mandatory risk assessment. A small firm can live with the new pricing.

    By the way … we’re good … but we still have to pay smart kids to engage them. I suggest you flesh out an org plan that will work and be sustainable. Remember, we’re in a capitalist economy and smart kids go where the money is.

  17. Chicago Accountant
    Chicago Accountant says:

    Anon @ 11:33:00 AM…

    [slow clap to full applause]

    Very good points.

    Oversight for the Better…

    My point is not that all government workers are inept. There are very competent people in government. However, people usually don’t go into government to make money (less people like the Illinois Governor). I would not mind doing some public service now or in the future. I am always open to that and would take a pay cut for it. I just don’t want my hand forced.

    While I am on Gov. Blago, corruption isn’t limited to Corporate America. You can have a bad audit partner and you can have a bad government audit director. Government is not the solution to every problem.

  18. Anonymous
    Anonymous says:

    So it would be appropriate to say, “Shaquille O’Neal is bigger than I”?

    You would normally say that sentence that way?

  19. Anonymous
    Anonymous says:

    Yes, when speaking I would use “me” since it’s just easier to say, sounds less pretentious, and most people use it in every day spoken language. I’d also probably use me if I were blogging (blogging is informal in my opinion). But, that doesn’t make it correct. When formally (grammatically correct), “I” is appropriate.

    I think everyone can agree that we use “I” when it is the subject of a sentence/phrase and “we” when it is the object. So, which is it?

    This is a debate that has been in existence for many years now. The answer lies in how you classify the word “than”. You can classify “than” as either a conjunction or a preposition. Conjunctions require a subject use and prepositions require an object use. See this article for a nice description of this mess:

    Let’s use your example. “Shaquille O’Neal is bigger than I” is correct. Think of it this way: “Shaquille O’Neal is bigger than I (am)”. I is the subject of the second part of this sentence “I (am)”. One would never say “Shaquille O’Neal is bigger than me am”, would they?

  20. Anonymous
    Anonymous says:

    The problem with that logic is that you are inserting an implied verb at the end of the sentence, which you can’t do. What is to say that “am” is the right verb to insert? Why not “thought”? or “imagined”? or “remembered”? All of them change the context of the sentence.

    The problem with “Shaquille O’Neal is bigger than I” is that it leaves the reader hanging. It is an incomplete sentence. Shaquille O’Neal is bigger than I… what? If you wish to convey that he is bigger than you are, than say “Shaquille O’Neal is bigger than I am” (than is a conjunction here), or “Shaquille O’Neal is bigger than me” (than is a preposition here).

  21. Dear Dear
    Dear Dear says:

    I am surprised at the vehement debate regarding you, I and than. FM, I think it would be best to have one word blog titles.Make sure you use appropriate capitalization…thankfully I do not believe you would need any punctuation! Better, yet just number them!!

    I thought this was an accounting blog, as long as she is not using horrendous grammar, I say move on! Either you had a bad day, or you are just in the mood to tear someone down. This is absurd!

    Nice post FM!

Trackbacks & Pingbacks

  1. […] sounds something like my suggestion in January of 2009 for a National Service Corp for Accountability and Transparency – a way to put all of the currently in-transition accounting, audit and forensic specialists […]

  2. […] government control of audits of companies taxpayers are significantly invested in, utilizing a Service Corp for Accountability and Transparency made up of the professionals the firms are irresponsibly […]

  3. […] too. Dear Francine,   I guess the US audit profession just isn’t getting your message regarding the current audit crisis and the change that is needed at the very top levels…to better protect the public interest that you have documented in detail on February 9, 2009.   […]

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