The U.S. Department of the Treasury established the Advisory Committee on the Auditing Profession to develop recommendations to ensure the "sustainability of a strong and vibrant public company auditing profession." The Committee's blue-ribbon membership was drawn from a wide range of professions and experiences.
The Committee issued more than 30 recommendations in its October 2008 final report. Many are "motherhood and apple pie" ideas that, while sounding nice, will do little to change the real landscape. Here are some of the more meaty suggestions that deserve to be implemented:
1. SEC regulations require disclosure of (i) any disagreements on financial disclosures during the preceding two years prior to a resignation or termination of an outside auditor, and (ii) any issue that may put into question financial disclosure reliability. The SEC rules do not require a public company to provide a reason for the auditor's departure. Approximately 70 percent of the time, SEC registrants fail to disclose any reason for their auditor changes. The Committee recommends that the SEC amend Form 8-K disclosure on auditor changes by requiring plain-English explanation of the reason(s) for the auditor change. The registrant would also disclose whether its audit committee agreed with the disclosure.
2. To avoid a disaster similar to the Department of Justice's (DOJ) execution of Arthur Andersen, the SEC would have the opportunity to inform the DOJ of the consequences that would result from a potential charging decision against a public auditing firm (as distinct from individuals within a firm). Accordingly, the DOJ should inform the SEC prior to bringing criminal charges against a firm.
3. In the case of any severe distress (financial or criminal) that might cause the failure of one of the large accounting firms, the SEC could appoint a court-approved trustee to seek to preserve and rehabilitate the firm, including through a financial reorganization. If such a step were unsuccessful, the SEC could pursue an orderly transition.
4. Require production of audited financial statements in accordance with generally accepted accounting principles (GAAP) by the largest accounting firms. However, in a rift that divided the Committee, the report did not recommend that such financial statements be made publicly available. Since the GAAP-based financial statements would include reserves for litigation losses, this author suspects that some of these financial statements will show that some firm(s) are insolvent, or nearly so.
The Committee voted against arguably the most important area involving the "sustainability" of the largest accounting firms; namely whether legal liability limitations should be adopted. Certain Committee members proposed changes that included (i) caps on the damages paid by auditing firms, (ii) caps on appeal bonds auditing firms must post, (iii) permitting auditing firms to appeal denials of motions to dismiss, (iv) strengthening the bankruptcy defenses available for auditing firms, (v) revising SEC Rule 10b-5 to utilize an "actual knowledge" standard, and (vi) providing government insurance for auditing firms.
These proposals were considered because of the profession's large litigation exposures. The six largest auditing firms disclosed they currently are defendants in ninety private actions related to audits with damage claims in each case in excess of $100 million. Forty-one of these cases seek damages in excess of $500 million, twenty-seven cases seek damages in excess of $1 billion, and seven cases seek damages over $10 billion. None of the largest firms could sustain a multiple-billion loss. The same six largest auditing firms indicated that the weighted average of "litigation and practice protection costs" was 6.6 percent of total revenues, and an even more staggering 15.1 percent of audit-related revenues for the most recent fiscal year.
Although all the firms face liability challenges, KPMG provides a clear example of how current events could reduce the Big Four to the Big Three. KPMG had already been saved Arthur Andersen's fate through a 2005 deferred prosecution agreement with the New York Attorney's Office over fraudulent tax shelters that the firm marketed. KPMG's concentration in the financial services industry means that they have plenty of additional plaintiffs looking to second-guess KPMG's work. As an example, an independent report commissioned by the U.S. Justice Department concluded that KPMG either helped perpetrate the fraud at Federal National Mortgage Association (aka Fannie Mae), or deliberately ignored it. KPMG's other unqualified audit opinions of credit crunch failures include Countrywide Financial and now-bankrupt New Century.
In the United States, the largest four auditing firms audit nearly 98 percent of total public company market capitalization, 98 percent of the largest public companies (those companies with over $1 billion in annual revenues), and 99 percent of total public company revenues. The Sarbanes-Oxley Act (SOX) replaced auditor self-regulation with the Public Company Accounting Oversight Board (PCAOB), a private, nonprofit corporation overseen by the SEC. SOX provided the PCAOB with registration, reporting, inspection, standard-setting, and enforcement authority over public company auditing firms. Any changes that come from this report will ultimately be administered by the SEC and/or the PCAOB.
By David Nolte, Principal, Fulcrum Financial Inquiry LLP
Fulcrum Inquiry performs financial investigations and related expert witness testimony.