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Monday, 24 November 2014

Final Four

Enron's worst legacy: auditors too big to fail

Ten years ago this week, accounting firm Arthur Andersen sealed its sorry fate when a few partners in its Houston office decided to shred documents related to the collapse of one of its clients, Enron. The ensuing prosecutorial zeal, however, created a different problem, whose effects are becoming apparent today - moral hazard in the audit industry. With just four big firms left to comb through the accounts of the world’s multinationals, watchdogs are justifiably worried that they can’t afford to lose another green eyeshade. If unchecked, this could lead to shoddy auditing.

Andersen’s criminal indictment sent a simple, deterrent message: help cook the books and your business is toast. Yet Andersen’s demise led to a concentration of the might of Deloitte & Touche, Ernst & Young, KPMG and PriceWaterhouseCoopers. They scour the books of 98 percent of American companies with revenue over $1 billion, according to the Government Accountability Office. On the Department of Justice’s preferred gauge of competitiveness, the Hirschman-Herfindahl Index, the industry qualifies as super consolidated.

This lock on auditing hasn’t necessarily resulted in price gouging. While audit fees have risen substantially since Andersen went bust, much of that can be attributed to the passage of new rules, such as the Sarbanes-Oxley Act, rather than competitive dynamics. That legislation, passed shortly after the Enron debacle, required accountants to simply do more work before they, and the executives at their client companies, signed off on company financials. Fees in 2004 jumped more than 45 percent, according to Audit Analytics.

But that makes it all the more perplexing that in the years after the corporate world adjusted to the changes forced upon them by Sarbanes-Oxley, audit fees actually started trending down. In 2009, fees averaged $569 per million dollars of revenue, down 6 percent from where they stood four years prior, even though the workload required under Sarbanes-Oxley and other new regulations increased. If auditors aren’t raising rates in line with more laborious fact checking, that raises the question of whether corporate accounts are getting the full treatment they deserve.

Cutting corners is a surefire way to make a lower fee structure work. And though professional pride should keep auditors honest, there is no appetite among regulators, or indeed investors and audit clients, to see the Big Four become the Even Bigger Three. A belief that none of the remaining giant audit firms will ever be put out of business like Andersen could undermine effective risk management.

In this context, it’s worth noting last week’s public censure of Deloitte. The Public Company Accounting Oversight Board, a watchdog set up after Enron’s collapse to police the audit industry, told the firm privately in 2008 that its quality controls weren’t up to snuff. The firm had 12 months to rectify the situation. It didn’t, so the PCAOB went public with previously undisclosed findings. Among these, the regulator said Deloitte hadn’t done enough homework to give an opinion on some of its clients’ books.

Public shaming is one thing, but in a highly consolidated, quasi-monopolistic, business there’s a hazard that members of the Big Four don’t have to worry as much about whether their actions will sink their company. The 2008 banking panic painfully exhibited the risk of creating institutions perceived as too big to fail. The European Commission could propose a new law in November that would ban the Big Four’s ability to audit while providing consulting services to their clients or face being broken up. The PCAOB is mulling mandatory auditor rotations to fend off complacency. These are starts.

The optimal solution for companies and investors would be to see an increase in the number of firms capable of auditing big companies. More than two decades ago there were eight. Of course, as corporations become more global, the need for economies of scale may require fewer, larger firms. Still, the right number is probably more than four.

Andersen’s collapse offered just such a chance for a new entrant to emerge. Instead its work was simply absorbed, which suggests the only way to increase competition in the industry is for the incumbents to break into pieces. That ought to be motivation enough for auditors to do a better job than ever before.

Context News

On Oct. 23, 2001, Arthur Andersen partners decided to shred documents related to Enron’s accounting. The firm went on to destroy tons of paper over the ensuing weeks, leading to a criminal indictment by the Department of Justice and Andersen’s demise.

According to the Government Accountability Office, the Big Four firms audited 98 percent of companies with revenue over $1 billion and 92 percent of those between $500 million and $1 billion in 2006. The Hirschman-Herfindahl Index (HHI), a measure used to gauge industry concentration, put the audit industry at 2,300. The Department of Justice and Federal Trade Commission say anything above 1,800 is highly concentrated.

Audit fees increased dramatically in 2004 due to new regulatory requirements under Sarbanes-Oxley, but then leveled off and began trending down again, according to Audit Analytics data. Fees per million dollars in revenue, for example, rose 45 percent to $601 in 2004. By 2009, they were running at $569.

The Public Company Accounting Oversight Board, the industry’s watchdog, disclosed earlier this month serious failings at Deloitte & Touche that it previously kept private in a 2008 inspection report. The board said that it keeps criticisms of individual firms private unless the company fails to address them within 12 months.

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