Re:Balance -- Jim Peterson

The SEC Turns Up the Heat on Climate Change -- Or Just More Gas?

2010-02-02T11:09:04-06:00

The Securities and Exchange Commission in Washington voted by 3-2 last week to issue an “interpretive release” aimed at public company disclosures of the impact of climate change – ranging from new regulations and legislation, to changes in economic trends or physical risks (here).

Yet another layer of mandated environmental platitudes?

In her announcement speech, Chairman Mary Schapiro disavowed any intent to “create new legal requirements or modify existing ones,” and stated (her emphasis) that the Commission is “not making any kind of statement regarding the facts as they relate to the topic of ‘climate change’ or global warming’.”

Further pounding down another nail of obvious banality, she noted that “it is neither surprising nor especially remarkable for us to conclude that of course a company must consider” possible events which “under our traditional framework” it must evaluate and disclose if material.

So the SEC’s cheerleading on climate change will be right there with the influence of the pom-pom girls on the outcome of the Super Bowl.

The SEC has been in rehabilitation mode since the prior administration, for everything from being caught out by Bernie Madoff’s spectacular Ponzi scheme to its virtual absence during the credit crisis. (see Andrew Ross Sorkin’s thoroughly engaging “Too Big To Fail” (Viking Penguin 2009), for the shared view that the then-Chairman was a clueless and ineffectual lightweight.)

The agency’s October 8, 2009 strategic plan has been followed by an outpouring: creation of a division for Risk, Strategy and Financial Innovation (November 5), borrowing of “cooperation incentives” from the toolkit of serious criminal prosecutors (January 13), and re-shuffling of bodies and titles within the Division of Enforcement (also January 13). Here then, the appearance of another release du jour.

Or so it seems – because it can hardly be justified on the substance. Rather than real regulation, it’s the Potemkin façade of illusion – animated by the same optics-oriented spirit that inflicted on the user community the costs, disruptions and distractions of the Sarbanes/Oxley law.

With details still to come, the SEC’s release offers four so-called “triggers’ whose impact could lead to disclosure – legislation and regulation, international accords, indirect consequences of regulation or business trends, and physical impacts of climate change – each of which would already have been unexceptionally viewed as an appropriate disclosure category under pre-existing guidance.

It offers a fair question: where the carbon set-offs will be found, for the acres of forest and tankers of jet fuel that will be consumed and emitted, to support all the round-tables, seminars and symposia, expensive legal opinions and auditor box-ticking, that will enable registrants to react to this latest burst of regulatory hot air.

What might be some of the new language, on top of disclosures that are already vaporous enough?

“The company safeguards its portfolio of exotic derivatives in an eco-friendly black box, which is regularly re-valued by marking to a market that is completely organic.”

“While the company’s internal control structure may not prevent our shopping-addicted CFO from stealing us blind, we are pleased that our corporate credit card accounts are now settled by paperless invoicing.”

“Any facilitating payments made to public officials by our off-shore subsidiaries will be delivered in brown paper bags made of no less than 60% recycled material.”

Kidding aside, validation of the importance of climate change is plain from its prominence in the marketing of each of the Big Four (here, here, here and here) – so nearly identical and undifferentiated as to be products of the same publicity shop.

The accountants had best be ready, because the financial and reporting issues around climate change will become real – from the complexities sure to arise when the inventive wonks in the derivatives markets develop exotic ways to re-package emissions permits for speculative purposes, to the management and audit issues of identifying and controlling pollution sources for purposes of permit measurement and compliance.

But for now, with the SEC already fully occupied with credibility-stretching issues, it is hard to see its exercise in non-substantive flag-waving as anything more than a needless contribution to the already-elevated level of Washington’s noxious fumes.

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Medical Check-Ups and Annual Audits: What if Your Doctor Reported Like Your Accountant?

2010-01-24T09:47:24-06:00

Now being the winter of our discontent, the political scene in American is dominated by the rancorous wrangling over health care and insurance reform legislation.

In that context, I was exchanging notes with my friend the insurance industry risk-manager, over our recent annual physicals, and fell to musing about the comparability of a financial statement audit and a personal physician’s examination.

Raise the question of personal health around a table of the reasonably responsible. The “organ recitals” of those surveyed will include familiarity with their own particular concerns – whether blood pressure, good and bad cholesterol levels, resting pulse, bone density, or hormone levels.

To achieve that awareness, on a periodic and routine basis, patients are poked and prodded and invaded in various intrusive and unpleasant ways – they give up samples of fluids and tissue for laboratory scrutiny, and they are screened and hitched and wired to exotic and expensive diagnostic machinery

The population of the diligent will also be subjected to inquiry by their doctors about their major behavioral risks – does their personal “control structure” include taking their medications, watching their cocktail intake, wearing their seatbelts, and avoiding handguns.

And then they receive several pages of detailed results, calibrated to standard norms of tolerance, and a briefing on what their trends are and what they might need in aide of maintaining or improving their well being.

Suppose instead, along with a bill whose magnitude is itself a threat to good health, the physician delivers this report:

“We’ve done a number of tests, the scope and results of which you don’t have, and we chose not to do a number of other, unspecified procedures.

“We’re not sure, but we think you’re unlikely to die of natural causes any time soon.

“Thanks -- we’ll see you next year. Be sure to pay on the way out. And have a nice day.”

Unacceptable – even with the multiple dysfunctionalities that render American health care an embarrassment among the world’s developed countries.

Does an audit report convey anything more about the health of a corporate body?

A company’s management may be well informed or sclerotic. Its products and strategies may be world-class, or senescent. It may be the equivalent of a gold-medal athlete, but with a malign and life-threatening growth lurking or metastasized.

But the only available opinion is that, within the tolerance of undisclosed measures of materiality, its financial health is generally fair.

Does the company need the corporate equivalent of a slimming regime of diet and exercise? Are prescriptions indicated to bring the basic operational chemistry within tolerable limits? Something surgically targeted like joint replacement or a major arterial by-pass? Radical intervention or experimental drugs?

At the cost of millions of dollars, no such diagnosis is on offer – but only a single anodyne page, in the same language handed out once a year to every other patient who passes through the annual audit clinic.

An auditor’s report tells less about a public company’s health than a doctor’s report tells about an individual – in scope, detail and precision. And if investors and other financial information users are not happy, they are doing nothing to make their dissatisfactions effectively known.

It may be, as Mary Poppins puts it, that “a spoonful of sugar makes the medicine go down.” But in the audit environment, patients are getting only sweets and placebos – and still paying for the dubious privilege.

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Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations

2010-01-18T09:51:32-06:00

“No such thing as a failed experiment …. only experiments with unexpected outcomes.”-- American engineer-architect R. Buckminster Fuller

Is the Big Four’s concentrated control of large company audits a real problem? Persistent voices of concern and attention extend back at least to the 2006 study for the Financial Reporting Counsel (here), recently joined by global leadership of BDO and Grants (here and here).

If so, is there a credible case to incentivize their exchange of market dominance for liability limitations?

Those issues were addressed this month in a paper from the American Antitrust Institute – here. In an all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With pending claims totaling billions of dollars, the Big 4 audit firms face serious threats to their survival…. (L)iability exposure substantially exceeds the combined partner capital of the Big 4 firms… (They) contend that liability limits are necessary to prevent the loss of another Big 4 firm, which would throw the global financial system into chaos. (footnotes omitted)

The AAI’s suggestion would be a legislated trade-off: “government incentives to break up the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned on a firm divesting itself of, say, 20% of its domestic revenue and the personnel serving the surrendered clients.

Can’t work – because of the many problems with the underlying but unachievable assumptions.

But before getting there -- the AAI deserves credit at least for recognizing the completeness of the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250 million” (emphasis in original) – with even tighter limitations on auditor choice in such industries as metals and mining, energy, air transportation and financial services.

Start with the political unacceptability of liability capping at a level that can assure Big Four survival. I have spelled out before (here) the financial limits of the large firms’ private partnership structure and their membrane-thin working capital, under which they cannot withstand litigation shocks above the $1 - $2 billion range – a tiny fraction (by either amount or percentage) of the exposures in their pending lawsuit inventory.

As the AAI paper summarizes, critics of liability protection point to the firms’ average litigation payouts, as a percentage of revenues and as compared to the far larger total of alleged damages. They fail to recognize – as do the arguments for capping from the profession itself -- that averages are meaningless when the “outlier” of a single verdict, falling outside the misleading comfort zone of a bell-curve model, could and would be devastating.

So: because American politics offers no cover for protection at those levels, that side of the proposed AAI bargain is no solution. What of the other side -- the plausibility of large-scale competitors emerging from the suggested divestiture program? The facts dictate otherwise.

First, an abundance of small practices already exist. Why they have not coalesced into global-scale practices is a long-familiar story of limited geographic scope, expertise, risk appetite and readiness to invest.

Second, the smaller sector does not inspire confidence in its strength or capacity for quality growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a deathwatch, facing the post-appeal enforceability of its $521 million jury verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins just received a seven-year prison sentence – now faces the fall-out of being fired by Koss, its public but family-dominated Milwaukee client, whose CFO managed for years to steal amounts in excess of the company’s total net revenue (on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a practical matter, how would global-scale competition emerge? If a Big Four firm were to hive off a small geography-based practice, that newcomer would suffer handicaps of capacity and expertise no different that those of the current smaller firms. If a large firm were to shed an entire industry practice, no new competition is added to serve that industry. And if instead, it were to divide a viable large-scale practice, then each of the two sub-practices would be burdened with shortages of expertise, personnel and the capital strength necessary to build to scale and withstand their risks.

In summary, the AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in logic I described (here) in the comparison of a failing situation against an idealized state, without recognizing that the assumed achievement is impossible under real-world limits, flaws and constraints.

The large firms grew that way for service-based reasons. And dreams of expanding the population of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the AAI’s most seriously under-examined assumption is that the “catastrophic” disintegration of another Big Four firm “would throw the global financial system into chaos.”

Why so? To the contrary, if the now-standard auditors’ report were suddenly not to be obtainable from any source, who would miss it?

Regulators and politicians would have convulsions, to be sure. But as the financial crisis itself has shown, that is daily practice for office-holders in the hermetic confines of Washington and London and Brussels.

Should the stock exchanges be closed, if a Big Four failure meant that one-quarter of the large listed companies lacked an audit report? Could those companies’ securities be barred from trading? Unthinkable. Out where capital really flows and trade is actually engaged, the world’s markets would shrug, start the process of designing new forms of assurance from a blank page, and move on.

And the splintered pieces of the former Big Four would provide ample building blocks for a new assurance structure – without, pace the AAI, any need or use for the unintended and unpredictable hazards of another failed experiment.

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