This Wall Street Journal ($) article picks up on the theme of this post from late last year — i.e., that the government’s regulation of accounting firms through criminalization of their services is contributing to the shortage of accounting firms that have sufficient resources to provide the specialized services that big companies need:
Intel Corp. is one of the many big companies now bumping up against the limitations. After using Ernst & Young LLP as its auditor for more than three decades, the semiconductor maker considered switching recently for a fresh look at its financials. But it stuck with Ernst after receiving proposals from the other Big Four firms: Deloitte & Touche LLP, KPMG and PricewaterhouseCoopers LLP. That is because federal regulations bar the three other firms from serving as Intel’s independent auditor unless they give up valuation, computer-software and other work they do for Intel.
Worries about the shrinking number of top-tier auditing firms began mounting with the collapse of Arthur Andersen LLP in 2002, after its conviction for obstruction of justice tied to its audits of Enron Corp. (The conviction was reversed last month by the Supreme Court.) The Sarbanes-Oxley corporate-governance act, passed by Congress in response to the accounting scandals at Enron and elsewhere, has complicated the situation, as well, by forbidding auditors from providing certain nonaudit-related services to audit clients. The restrictions, aimed at enhancing the independence of auditors, have led some companies to distribute nonaudit work to the other Big Four firms. But that puts these companies in a bind if they want to switch auditors.
Meanwhile, KPMG is learning that playing nice with the Justice Department may not be all that it’s cracked up to be. As noted here last week, the threat of an indictment has KPMG pursuing a settlement of the government’s criminal investigation into its promotion of tax shelters under a deferred-prosecution agreement. As a part of that effort, KPMG issued a well-publicized admission of wrongdoing and public apology last week regarding its involvement in the tax shelters.
However, as a result KPMG’s public admission, this NY Times article reports KPMG is now a sitting duck for damages in the myriad of civil lawsuits involving the tax shelters and even unrelated accounting issues, and that KPMG’s co-defendants in the tax shelter civil cases are furious over the financial implications to them of KPMG’s public admission of wrongdoing.
All of this is having a devastating effect on KPMG financially. KPMG reported earlier this year that it had revenue of $4.1 billion last fiscal year, but that “practice protection costs” — i.e., insurance, legal fees and litigation settlements — were running at the staggering amount of more than $400 million annually, or more than 10 percent of the firm’s revenue.
Thus, the cost of avoiding an indictment might just cause KPMG to meltdown anyway. At very least, the cost of cooperation will cause substantial financial damage to the firm, resulting in job loss and less competition for audit services for big companies. And let me get this right — this is a “business-friendly” Republican Administration pursuing these policies?
Do you have a reasonable alternative to hold the auditors accountable when they play fast and loose with the law? You seemingly want to give the auditors a free pass on Sarbanes-Oxley ‘for the good of the business community.’ What do you propose we do to serve the interests of the investing public (the actual constituency of the independent auditors)?
Indeed, we do have a lack of large accounting firms today. However, couldn’t one argue that we are simply witnessing the death of the old accounting business model (where wrongdoing was looked at as ‘business as usual’)? The marketplace will adjust and new accounting firms will step in to fill the void left by the ethically challenged accounting firms.
I say we enforce the laws as is being done by prosecutors, allow the ethically challenged firms to fall by the wayside and let the marketplace fill the void. This will better serve the business community rather than giving wrongdoers a free pass on Sarbanes-Oxley or turning a blind eye to the malfeasance that has permeated the culture of corporate accountants.
If the old guard accountants are scared for their future its their own fault. They dug their own graves.
Charles, thanks for your comments and for reading Clear Thinkers. The press of work prevents me from being as thorough as I would prefer in my response, but I want to pass along a few threshold thoughts.
The problem with this policy is that the government is prosecuting agency costs, such as KPMG pushing the edge of the envelope on tax shelters or Andersen not using very good sense in executing its document retention policy. There is a big difference between prosecuting agency costs and prosecuting clear-cut crimes, such as embezzlement. The difference relates primarily to the nature of the evidence involved, the relevance of contracts, and the subtleties of dividing responsibility between corporate actors.
Professor Ribstein has put it this way. Suppose somebody mugs you on the street. There is no question that is a crime. However, what if they ask you first if they can borrow your wallet, you loan it to them, and then don’t give it back in time? What if they ask your employee who’s running the store for you whether they can borrow some money and then don’t pay it back? What if the “thief” is another employee who says the manager gave him the money as bonus compensation?
Who is liable in these situations turns on the contracts among the various parties. Proof depends on who said what to whom. Can we rely on what the witnesses say about this? What if the prosecutor tells the guy who’s minding the store that he’ll not face a prosecution for conspiracy if he spills the beans on the employee?
Take the Tyco case as an example. It was widely reported yesterday that the jurors in post-trial interviews said that they convicted Kozlowski and Swartz in part because they assumed the directors were so firmly in the defendants’ pockets that they would have provided a writing if the defendants had asked for it, and therefore it follows that the defendants didn’t ask for it. But why wouldn’t the defendants have asked for such a writing if they surely would have gotten approval? Not because they wanted to hide their bonuses because there was evidence that the bonuses were well known within the company and by the company’s auditors. Consequently, shouldn’t the directors have faced prosecution also for allowing such excess compensation? Shouldn’t the auditor (Richard Scalzo) also have been prosecuted? Similarly, in the Enron case, if Arthur Andersen is prosecuted, shouldn’t Vinson & Elkins be prosecuted for their far more egregious conduct in facilitating Fastow’s SPE’s and covering up their invalidity in connection with their investigation into Sherron Watkins’ memo to Ken Lay?
I concede that society needs to have some punishment and accounting for clear-cut crimes. But in the Tyco case, the shareholder suits are still pending and they include — unlike the criminal prosecution — all the people involved, including the directors who approved the wrongful payments and the accountants who knew about them. My sense is that this is a much more rational way in which to deal with agency costs than attempting to make them appear to be clear-cut crimes, which is something that they are not.
The supposed payoff to criminal prosecutions of agency costs is deterrence. But businesspeople such as Kozlowski will keep on pulling these shenanigans while the legitimate risk-takers who create jobs and wealth for the community sorts will be the ones who are deterred. I’m not suggesting that the conduct in Tyco should be encouraged, but the cases against Mike Milken, Hank Greenberg, Jamie Olis or Dan Bayly are significantly different, and I am not comfortable that politically ambitious prosecutors such as Eliot Spitzer can tell the difference.
Again, Charles, thanks for taking the time to comment and thanks for reading Clear Thinkers.