Balance Sheet:
What it would take to bring down another big accounting firm
By Jim Peterson
Business vocabulary borrows freely
from the military: control battles, hostile raids, road warriors, chain of
command.
Today's example is this axiom of
warfare: "You never hear the bullet that kills you."
Last week I was with a retired
partner of a Big Four accounting firm who has plenty of reason to be on full
alert for silent killers: His pension is contingent on the doubtful durability
of the large firms' cartel to audit the world's large companies.
The discussion of possible changes in
the regulatory regimes for corporate financial reporting is rapidly expanding.
It includes a full menu of ideas proposed in
Those antagonistic views are based on
the disbelief that there will be another collapse. That, in turn, is based on
the persistently erroneous view that the disintegration of Arthur Andersen in
2002 was caused by its Enron-related indictment.
Hear this now: The unheard deadly
bullet was Andersen's litigation exposure. And that has grave implications for
the remaining Big Four.
How likely is it that another big-
firm implosion could happen? As with Andersen, it would involve an
emotion-driven breakdown in confidence — the simultaneous outflow of clients,
collapse of an international network and flight of partners.
Although client flight will be
severely constrained the next time around, with the lack of auditor choice
available when the current Big Four drops to three, the other two factors can be
quantified. And it's not a matter of exposure to prosecution.
While we await a promised talking
paper from Charlie McCreevy, the European Union commissioner for internal
markets and services, a supporting report prepared for him on Oct. 4 by London
Economics, a consulting firm, has calculated the size of the litigation hit that
would disintegrate a large European linchpin accounting practice.
The report's assumptions, extended to
the more threatened
To set the stage, recall that there
are three reasons why the large accounting networks are forced to finance their
large litigation settlements out of their partners' future profits:
First, by local codes they are barred
from access to public shareholders or other equity investment.
Second, the partners' personally
invested capital is on demand for working purposes.
Third, the insurance market no longer
provides real risk transfer, but instead is at most a source of time- shifting
finance.
The key to survival, then, lies in
the willingness of the partners to stay committed and at their desks —
something that the Andersen partners did not possess, as proved by the two- week
period in 2002 during which they bailed out en masse and thus smashed the firm
beyond recovery.
The study done for McCreevy
calculates that the partners of a European firm would bolt, in numbers large
enough to be destabilizing, rather than be forced to finance a litigation
payment that extracted a profit reduction of 15 percent to 20 percent spread
over three to four years.
Applying those assumptions to the Big
Four's latest reported U.S. revenues of $4.7 billion to $8.7 billion (write me
if you want to hear the numbers crunch), the dispiriting result is that the U.S.
firms will confront partner flight and possible failure at liability levels as
small as $450 million and up to $1.8 billion.
Those amounts are modest to the point
of insignificance against the size of this decade's financial debacles —
examples ranging from the $20 billion hole in the balance sheet of Parmalat to
Enron's own $67 billion bankruptcy. Little wonder there is no public support for
liability caps in the auditors' favor at levels low enough to protect them from
collapse.
These assumptions also make plain
that the Enron-inflicted blow on Andersen was mortal. The firm's 2001 worldwide
revenue was $9.3 billion. It confronted plaintiffs' lawyers claiming that the
case would be the first against accountants to reach $1 billion. The crippled
firm was already dealing with claims involving Baptist Hospital, Waste
Management and Sunbeam, and it was about to receive the incoming bombardment of
WorldCom and Qwest, among others.
So to blame Andersen's death on the
Enron indictment misses the point. The firm was like a terminal patient on
late-stage life support who happened to succumb to a fast-moving staph
infection: Its demise was imminent, and inevitable.
The report this month to the U.S.
Treasury secretary, Henry Paulson Jr., on a broad-ranging set of proposals for
regulatory change notes that the Big Four's litigation inventory in the United
States includes 22 actions, each with damage claims exceeding $1 billion — and
that's without contemplating their lesser but not trivial cases, or the new
matters that will inevitably arise in the months to come.
All of these will eventually be
settled; witness the announcement last week that Deloitte will settle the
shareholder piece of its Adelphia litigation for $210 million. Managements are
too risk-averse to risk a life-threatening jury result at trial.
The Big Four might each survive one such impact from this barrage of lawsuits — although even that is a big if. But a second direct hit on any of them would be the last explosion they ever heard.
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