Paul Danos, Dean Tuck School of Business at Dartmouth.
(Published on Forbes 13th April)
When I was a full-time professor of accounting in the 1970s and
1980s, the industry was dominated by the "Big Eight" accounting firms.
After a series of mergers and the 2002 Arthur Anderson collapse, we are
now down to the "Big Four." And that's really a big danger.
Anyone
who understands the implications of our legal system and who witnessed
the end of Arthur Anderson knows that the "Big Four" could easily
become the "Big Three" in a similar manner, but the truth is that such
a shift would be much more damaging to our economy than most people
might think. In fact, the dangers posed by this threat might just be
serious enough to warrant a thoughtful attempt by policymakers to come
up with a solution before a crisis hits.
Today, the Big Four
accounting firms (namely Deloitte & Touche, Ernst & Young, KPMG
and PricewaterhouseCoopers) do almost all of the public firm audits for
the entire world. The reality is that the fifth largest global
accounting firm is much, much smaller than the Big Four, so it is very
unlikely that it could rapidly grow to their size.
Each of these
four firms works with several hundred publicly traded companies, not
just as auditors but in other functions as well. Current rules
generally prohibit the same firm from serving multiple functions for a
single client (so, for example, a company can't have a significant
consulting job being done by its auditor) and the result is that many
companies get a second firm for consulting, and perhaps even a third to
handle tax issues.
If, for some reason, a company needs to find
a new auditor, it may have only one other feasible choice at that
point. This environment means that it is already difficult for our
largest companies to retain an accounting firm that is not in some way
connected to, or overlapping with, or auditing their biggest
competitor. If the Big Four were to become the Big Three, finding
independent auditors would, of course, be even more challenging.
In
addition to the difficulties associated with maintaining independent
accounting firms, there is a second serious risk of consolidation,
which is the economic cost of the disruption. The problem is deeply
connected to our whole reporting structure, which requires that
publicly traded firms put out annual and quarterly reports audited by
an independent firm.
If one of the Big Four were to go under,
roughly one fourth of all publicly traded firms would be in a serious
bind when it comes to meeting regulatory requirements. When Arthur
Anderson collapsed, it took the market some time to deploy all of the
professionals who were employed there to the other large firms, and, of
course, that impact would only be bigger if one of the four remaining
firms fell. Just the disruption alone would probably cost billions of
dollars, in addition to the long-term structural problem.
The bottom line is that a Big Three scenario simply may not be viable in terms of our overall economy.
So, could it happen?
Given
our legal system today, there is simply no way to make the Big Four
accounting firms immune to collapse. Any firm can be sued for almost
anything, and most firms simply don't have either the insurance or the
capital to cover a billion-dollar judgment. The size of the lawsuit can
be completely unrelated to the size of the original job, so an audit
generating $10 million in fees could possibly produce a $2 billion
lawsuit. Even in the case of Arthur Anderson, Enron was only a fraction
of its total billing--certainly not big enough to lose the company over.
The
Arthur Anderson case also demonstrated that a single felony indictment
can start a devastating chain reaction. By law, if a firm is indicted,
it can't audit governments or companies who have governmental clients.
At the same time, many other clients will be scared off by the ensuing
publicity. The result is a death spiral where the firm finds itself
losing clients but not gaining any new ones. Arthur Anderson's
conviction was ultimately overturned, but only after the firm had
utterly collapsed.
This is a fundamentally risky business. That
risk, combined with the potential economic cost of another Big Firm
collapse, should give policymakers pause. If we're going to maintain
the private system of audits the way it is now, then it seems the SEC
needs to do something to create more viable firms. One approach would
be to move toward a rational five-year plan designed to take us from
four firms to eight firms. The largest firms could be motivated to
divide into independent units, and new regulation could encourage this
shift (for example, by limiting the overall percentage of any one
industry that can be audited by a single firm). Other approaches could
involve encouraging smaller firms to grow.
Ultimately, there is
no one actor who benefits from this shift, except society as a whole.
And that's why the SEC exists: to help protect our overall markets.
Finding a way to spread risk across a larger number of big global
accounting firms could avoid billions of dollars of economic
disruption, and is at least worth a careful look.
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