SEC Should Calm Markets, Ahead of Possible Audit Crisis

If you thought the 2008 credit crisis that temporarily froze global debt markets wrought havoc, watch out for the next shoe to drop.  At stake is the viability of global equity and other financial markets that could freeze if one of the four large auditing firms goes extinct.

And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.

Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public corporations. If one of those dissolved, its clients would have to scramble to find a replacement. Some of the remaining three lack requisite expertise for some of those corporations and others would be disqualified from auditing due to consulting work they do for them.

The result would be hundreds, possibly thousands, of large corporations who could not get their financial statements audited as required by US federal securities law. Stock markets could go berserk, along with other financial markets. The costs now, of moving from four firms to three, would dwarf those incurred when Andersen’s dissolution moved the total from five to four.

It does not appear that the US government, specifically its Securities and Exchange Commission, has any plans to deal with this prospect. It should. And it should announce them promptly to get ahead of any market crisis the failure of E&Y, or of the other three, would wreak. 

If not, the credit crisis of 2008 will look mild in comparison. After all, the credit crisis was readily addressed by government pumping enormous amounts of capital to rejuvenate liquidity; an auditing crisis cannot by solved by throwing money at it.

Allegations against E&Y are credible, making liability risk meaningful. The magnitude of potential loss certainly approaches $1 billion and may be much higher—alleged manipulations at Lehman ran to scores of billions of dollars.  E&Y, which self-insures against such risks and is unable to obtain significant external insurance, would face dissolution if compelled to pay such amounts.

The SEC should promptly prepare and announce steps to address that possibility. Alternatives, none of which is attractive and all pose costs, include:

* quickly seeking to break up the remaining three firms to eliminate conflicts of interest;

*quickly hiving off partners and resources of the existing E&Y (or other threatened firm) commanding expertise other firms lack, to enable them to continue auditing such clients; and/or

* relaxing auditing requirements or standards, by extending corporate audit deadlines or rules governing requisite auditor independence.

Though none of these is attractive or cost-free, they are far less costly than the probable costs  of market havoc that could result if no plans are made.    Longer term, I have laid out a series of prescriptions, in an article written a few years ago warning of the pending problem.

Observers should also watch the SEC closely as it participates in addressing the allegations against E&Y. SEC Commissioners, whose duties are to protect investors, will face a dilemma in evaluating how tough to be on the firm.

A tough line would be warranted in the name of protecting investors in Lehman Brothers, and signaling a commitment to audits of high quality.

But too tough a line would risk extinguishing E&Y, jeopardizing audit availability, and even equity market efficacy, for at least a meaningful period of time, wreaking havoc on investors.

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1 Response

  1. ohwilleke says:

    What ever happened to the notion that auditing functions needed to be separated from other functions of big accounting firms, which was supposed to have become law a few years ago (wasn’t it SOX that included these reforms)?

    Auditing is only a small share of the activity that goes on in big accounting firms. The change in the law was supposed to dramatically reduce the scale of operations involved in an auditing firm, and in turn, reduce the barriers to entry of new firms into the market (legally, all one needs to have to audit a firm of any size is to be a Certified Public Accountant, so the barriers are purely economic), by reducing the size of the big audit firms from tens of thousands of employees to hundreds or a couple thousand employees, in turn distributed regionally to some extent.

    The same law that mandates a separation of the audit function, also mandated changes in who audit contracts are bid for public corporations that was supposed to make shuffling of audit firms more routine, eliminating barriers that lock in and industry specialization had created to competitive bidding by firms and enhancing auditor independence.

    Also, what ever happened to the efforts of regional accounting firms to form federations that would rival the big four and potentially lead to new replacement big accounting firms. As of a couple of years ago, this industry consolidation through federations of mid-sized regional accounting forms was well underway.

    The problem identified in this post is a very real one. But, it isn’t obvious why the solutions already developing in the marketplace and on the books haven’t manifested.