The Accounting Industry and the Specter of Catastrophic Risk (Part 3)

What would happen if the existence of one of the Big Four was again threatened?

The 2008 Report by Treasury's Advisory Committee on the Auditing Profession discussed the concentration and noted that among the largest companies, the Big Four control the market. 

• In 2006, the four largest auditing firms audited 98% of the 1500 largest public companies with annual revenues over $1 billion and 92% of public companies with annual revenues between $500 million and $1 billion.

Id. at VII:1.  A GAO Study of concentration in the auditing industry in 2008 concluded that "[a]lthough current concentration does not appear to be having a significant adverse effect, the loss of another large firm would further reduce large companies’ auditor choice and could affect audit fee competitiveness."

The Treasury Report also noted the concern and made the following recommendation:

• The Committee therefore recommends that the PCAOB, in furtherance of its objective to enhance audit quality and eff ectiveness, exercise its authority to monitor meaningful sources of catastrophic risk that potentially impact audit quality through its programs, including inspections, registration and reporting, or other programs, as appropriate. The objective of PCAOB monitoring would be to alert the PCAOB to situations in which auditing firm conduct is resulting in increased catastrophic risk which is impairing or threatens to impair audit quality.

The Report also recommended that a mechanism be implemented for preserving and rehabilitating a "troubled larger auditing firm."  In other words, to the extent the firm confronts some type of risk of elimination, there should be a pre-existing plan to rehabilitate the firm and prevent its elimination. 

Certainly, the SEC took proactive steps during the demise of Andersen to at least notify clients that there would be greater administrative flexibility if, as a result of remaining with Andersen, they ultimately found themselves without a signed audit opinion.  See Exchange Act Release No. 45590 (March 18, 2002).  More could be done.  It should also be a high priority for the PCAOB.

But in truth the long term fix is to increase the number of firms that can compete for public company auditing business, eliminating the current situation, which is tantamount to too big to fail.  Yet this in turn can only be done through the development of meaningful standards for audit quality.  Currently there are none.  Audit quality is equated with firm size.  This by definition means that the smaller firms (the cluster of mediums sized auditing firms) cannot compete for business based upon audit quality. This is another task for the PCAOB. We will have much more to say about this in the future.

In addition, though, this case also points to the need to reform the audit opinion issued by accounting firms.  The opinion typically does little more than opine that the financial statements conform with GAAP.  Within these broad, unqualified opinions, are many many judgements.  Accounting firms are left with passing or failing the financial statements, with no room in the opinion for nuances.  The content of the opinion needs to expand and provide firms with an opportunity to issue an unqualified report to note issues of uncertainty or judgement.  Had E&Y noted the Repo 105 transactions in the opinion, the New York Attorney General never would have filed its case.

This is an area where attention has primarily focused on whether the auditing partner should have to sign the opinion.  While a fair enough issue, it pales next to the question of the substantive content that ought to be considered for the auditor opinion.   We will have more to say about this in the futue.