Sustainablog

This blog will cover some news items related to Sustainability: Corporate Social Responsibility, Stewardship, Environmental management, etc.

27.11.04

The world ?s regulator of last resort: the regulator who is coming up with the goods is NY Attorney General Eliot Spi

The world?s regulator of last resort
EC Newsdesk
18 Nov 04
Eliot Spitzer?s actions against embedded corporate malpractices are
gaining in potency and reach
A second term US President George W Bush promises an agenda rich in
pro-business action. Apart from tort and healthcare reform, there has even
been talk of resurrecting the ?Cheeseburger Bill? unsuccessfully floated
in the previous term to prevent obesity lawsuits against Big Food.

This is the King Canute approach to corporate accountability. Grassroots
pressure for better corporate behaviour when blocked does not disappear
but simply finds new channels for release. It is a golden rule of
regulation that stakeholders will pursue their concerns through successive
regulators until they find one that delivers. If politicians and
government regulators fail to grapple with an issue, they will use the
courts; non-governmental organisations, investors, the media, and anyone
else who can help them iron out wrinkles in their relations with business.


Increasingly, the regulator who is coming up with the goods when all
others have failed is New York Attorney General Eliot Spitzer, the man
described by the former Securities and Exchange Commission chairman Arthur
Levitt as ?the most effective protector of the public interest certainly
in the history of New York state, and maybe in the history of US markets?.
Agreed, and without the territorial qualification.

Sure bets

Take the case at hand: the global insurance industry that has been
traumatised since Spitzer?s issue of a complaint on 14 October against
Marsh & McLennan, the world?s biggest insurance broker.

Though an industry built on the acceptance of risk, insurance players
demonstrate a remarkable propensity for loading the dice. Insurance
brokers receive commission from insurance companies and advisory and
service fees from clients. Such advice is supposed to be in the client?s
best interests, but in a widespread industry practice insurers reward
brokers with substantial contingent fees if a broker places a specified
volume of cover with the insurer. Disclosure of such fees is often
inadequate and certainly insufficient to offset the glaring conflict of
interest they provoke.

Spitzer Wars: Episode III

While attacking these fees, the Spitzer investigation ? sparked by a
whistleblower - goes further, accusing the industry of widespread
corruption. The sheer extent of contingency fee payments betrayed the
inadequacy of regulatory intervention to date, throwing a supposed grey
area into black and white. Since January 2003 contingent fees had
contributed some $1.2 billion to Marsh?s revenues. Emails ? the staple of
a Spitzer probe ? revealed the dominant influence of contingent fees in
the broker?s selection of insurer.

Worst of all, Spitzer presented evidence alleging bid rigging arrangements
between Marsh and insurance giants including AIG, Hartford, and ACE.
Insurers were asked to submit uncompetitive bids so that Marsh could place
the cover with another insurer and so meet the volume required to trigger
payment of contingent fees.

The investigation has led to the resignation of Jeffrey Greenberg, Marsh &
McLennan?s chief executive, and the dismissal of other executives there
and at Ace. Criminal charges are expected against several executives at
Marsh and elsewhere. Three have already pleaded guilty to bid-rigging.
Negotiations for a settlement are underway with Marsh for disgorgement of
its contingent fees received over recent years, a figure estimated at $2
billion.

Reform at light speed

On 15 October, Marsh announced it would stop collecting contingent fees.
Aon and Willis ? Marsh?s two largest rivals - followed suit. This will
cost Marsh $800m in lost annual revenue ? about a third of the firm?s
profits. Marsh?s share price halved within four days. Marsh will disclose
all revenues and fees to clients and has set up a compliance group. Other
large firms are thought likely to introduce similar reforms.

The scandal, however, has provoked even more profound questions about
industry structure. Some are questioning whether costly and unscrupulous
intermediaries are really needed in the loop at all.

Where were the industry regulators?

As with the investment bank analyst conflicts of issue scandal at the
heart of Spitzer?s first foray against Wall St, regulators were aware of
the abuses at the heart of the present investigation but did little. With
the exception perhaps of the bid-rigging fraud, Spitzer has not revealed
anything new. He has simply been prepared to expose it as corruption where
industry regulators have failed to.

In the US, insurance regulation has been the province of state insurance
regulators, creating a patchwork of differing standards and degrees of
political will to enforce. The regulators are a hunting ground for
industry recruiters. In the UK, until January, when regulation of
insurance brokers comes under the remit of the Financial Services
Authority, insurance brokers are regulated by the General Insurance
Standards Council, a self-regulatory organisation. Market disquiet
prompted both the GISG and the FSA to look into the issue of broker
inducements earlier in the summer. The GISG followed up with nothing,
leaving the FSA, which lacked jurisdiction, to send a warning letter.

Clearly, fragmented and self-regulatory frameworks can give rise to too
cozy a relationship between the regulator and the regulated, leaving
stakeholder interests out in the cold. They undermine the political will
to rout widespread malpractice with structural change.

Along came Spitzer

Through a modus operandi that uses public outcry as much as legal process,
Eliot Spitzer helps create the political will for necessary deep-rooted
change.

Unlike industry regulators, he has no political masters beholden to
business interests and no institutional interest in nurturing an ongoing
relationship with those he investigates. This is the factor that permits
him to use publicity as a weapon the way he does and the SEC assuredly
does not. It also means his independence is assured, and as such he has
become a magnet for thousands of reports of malpractice in search of
elimination including the insider tip-offs that spurred the mutual fund
and insurance investigations. Although he is supported by a small,
dedicated team of some twenty attorneys, it is his face that is associated
with the output of his office. It is a potent antidote to faceless
bureaucracies like the SEC.

The attorney general is not restricted to examining particular sectors and
so can fill in the gaps between other regulatory institutions. Spitzer is
also very good at identifying stakeholder groups that have lost out, and
at identifying with their concerns. In doing so he acquires an army of
activists to wage the same war on their own fronts. In the UK, a survey by
the Association of Insurance and Risk Managers showed that almost half of
major UK companies are considering switching insurance brokers as a result
of the US probe.

His reputation has grown to the point that what, in relation to analyst
conflicts of interest, took months of negotiation, is now being executed
virtually overnight.

Distant tremors

Spitzer?s actions have a knack for waking regulators out of their
complacency, and creating the political will needed to drive reform. With
the industry softened up by Spitzer?s blows, many state regulators have
now instituted clampdowns and new requirements of their own, and several
other state attorney generals, the SEC and the US Department of Labor have
begun their own investigations. Even the US Senate is now planning to hold
an inquiry.

More striking, however, is the extent to which the New York attorney
general?s investigation prompts change and even regulatory cooperation
elsewhere. Analysts have already predicted that foreign insurance
companies with big US operations will find themselves drawn into the fray.
There are signs of international cooperation, too. The UK?s FSA, even
though it has yet to assume jurisdiction for insurance brokerage, has,
according to The Times newspaper, been helping Spitzer by setting the
terms of a review of Marsh?s UK operation.

Even without explicit co-operation, local regulators and firms are as keen
as US state regulators to demonstrate that they are on top of the issue.
The Lloyd's of London insurance market has backed calls for greater
disclosure of insurance commissions. South Africa?s largest broker,
Alexander Forbes, has made a public statement that bid-rigging is not
tolerated at the firm and was reviewing its business to see whether
contingent fees are in operation. The Hong Kong insurance commissioner has
called in the territory?s self-regulatory organisations to ensure they are
enforcing the insurance code.

Such international oversight contagion is becoming established as a
feature of global business. When Citigroup?s private banking unit was
closed down in September by Japanese regulators for a raft of compliance
problems, regulators in South Korea and Taiwan were quick to launch
reviews of their own on local Citigroup operations.

Open to all comers

The finance sector, of course, is not the only industry to have been on
the receiving end of Spitzer?s cattle prod. The energy sector has been
taken to task over emissions, pharmaceutical companies over their
selective disclosure of clinical trial results, the music industry over
bribes to radio stations to add songs to playlists, and even restaurateurs
over deductions from the tips of washroom attendants.

It would be strange if such far-reaching activity did not generate
criticism.

Comments are generated over turf wars with other regulators, to which
Spitzer responds that he will stop treading on the toes of other domestic
regulators when other regulators do the job with which they are charged.
The sooner the better; Spitzer?s bullwhip approach garners collateral
damage that a steady reform agenda could avoid, as 3,000 newly redundant
Marsh employees could testify.

Some ask, in what way is Spitzer competent to set about reforming whole
industries? Spitzer, though, initiates the implosion but does not
generally dictate the reconstruction. Still, there is merit in the
criticism levelled at Spitzer by SEC Chairman William Donaldson for
forcing mutual fund companies to lower charges as part of the fund trading
scandal settlements. As Spitzer?s deputy, David Brown, commented regarding
the insurance probe, they should seek merely ?real transparency and price
competition where insurance is sold everywhere?, then step back and see
what the market creates.

Yet others question from where stems the legitimacy of his de facto role
as global regulator of last resort. It would set a dangerous precedent, it
is argued, if local regulators started taking on cases with significance
beyond their jurisdictions, so interfering in the affairs of others.
Spitzer?s global impact, however, as for his domestic adherents, stems
more from raising public consciousness of the issues, creating grassroots
pressure and the political will for reform, and perhaps even from
inspiring other regulators and legislators, than from any direct
influence.

Rather than gripe, critics would do better to take William Donaldson?s
recent advice: take a good long look at their organisations for embedded
conflicts of interest that might not stand up to the glare of external
scrutiny, and eliminate them.

And, it should go without saying, best do so before Spitzer comes to call.

24.11.04

Multinational Executives Expect Compliance Costs to Increase

Multinational Executives Expect Compliance Costs to Increase

London, 23 November 2004 More than half of U.S.- and Europe-based
multinationals will increase compliance spending by an average of 23
percent during the next 12-24 months, according to PricewaterhouseCoopers'
Management Barometer.
Comparatively few consider their compliance programs "very efficient."


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23.11.04

Software for a safer, cleaner world: Regulations on reporting trade in emissions are renewing interest in applications to manage gases and chemicals

Software for a safer, cleaner world
Financial Times, 17 November 2004 - Regulations on reporting trade in
emissions are renewing interest in applications to manage gases and
chemicals, writes Phil Cain.
When the European Union's Emissions Trading Scheme comes into force at the
beginning of next year, many companies will start paying for the carbon
dioxide they emit in Europe. It could fuel renewed interest in
environmental and other non-financial reporting software - even now, some
of the world's biggest companies are using no more than a spreadsheet to
track how much CO they produce.
"Until now COreporting has been voluntary," says Charles Donovan,
commercial manager at Enviros, a UK-based environmental consultancy and
software company. "The EU Emissions Trading Scheme is the event which will
move people away from that. It helps to lower the payback period of
investment (in software)."
Environmental, health and safety software emerged largely to deal with
legislation brought in after the Bhopal chemical and Exxon Valdez oil
disasters in the 1980s. Then, companies' first instinct was to develop
grow their own IT solutions.
Only in the 1990s did specialist software developers emerge, and through
acquisition they are now offering a range of software designed to deal
with a number of common problems in the field. Among big-name enterprise
software companies, only Germany's SAP has managed to carve out a niche
with its SAP EH&S product - Oracle had a presence in the field but has
since retreated.
Maintaining productivity is a key reason for investing in the software.
"Companies don't want highly-qualified, highly-paid professionals doing
bureaucratic roles," says Jess Kraus, founder of California-based 3E,
which specialises in software to help companies deal with dangerous
chemicals.
Another company offering a broad range of environmental, health and safety
software is ESS, based in Arizona. Its software aims to answer the
question, "How do we manage chemicals and the environment and how do we
manage things if something happens?" says John Gargett, crisis technology
manager. Many of the problems which emerged from the September 11 attacks
were environmental, he points out.
Another more positive motive for companies to invest in software of this
kind has emerged with the belief of some companies that there is
commercial value in maintaining good reputations with investors and the
public, says Elizabeth Donley of US software consultancy Donley Tech. When
reports emerge of a company suffering an accident or having to pay a fine,
people tend to think more generally that they are not doing a very good
job, she says.
Ms Donley says that despite consolidation there are still more than 3,000
software products available. As well as tracking emissions these systems
help companies keep up with regulatory paperwork, monitor health and
safety, produce management reports and, in some cases, manage crisis
situations.
While many products deal with a single task, she says around 25 now
attempt to encompass a range of functions that are becoming more
comprehensive and more international in scope. However, "there is still
not a clear leader in the field and I don't see a dominant player emerging
right away," she says.
While there is a lot of software about, picking the right solution is not
easy. Apart from the nature of their business, factors such as the
territories a company is in, its environmental pro-activeness, attitude to
web-based technology and preference for a one-off software purchase or
ongoing service package all make the outcome individual.
Also, some energy companies still want to get involved in the development
process. Mr Donovan at Enviros says one "energy major" has shown it wants
a big hand in developing new software, taking a stake in the next version
of Montage, the software company's energy and emissions management
product. Another company, oil and gas producer BP, is among those using
Enviros' system to try to make energy savings, although it uses its own
in-house system for recording carbon and sulphur gas emissions.
BP, like Enviros' unnamed business partner, has in the past tried
developing software for itself with an eye to selling it on. Three years
ago, the in-house software package Tr@ction replaced BP's 20 existing
computer systems for tracking accidents where action is required -
everything from a fatality to the spillage of more than a barrel of oil.
"It is fundamentally a safety information system, but it has a major
management information spin-off use as a source of safety statistics,"
says Nick Coleman, vice-president of health and safety, security,
environment at BP. "You can see the likelihood of a twisted ankle in each
area of the US or compare the safety records of a gas station in Australia
with those in Oklahoma."
As well as feeding safety and incident information back to head office the
system allows each of its 30,000 users - site managers, health and safety
managers and admin staff - to compare their performance with others.
Fostering such a benchmark is helpful improving safety record of an
enterprise as big as BP where central control over safety is impossible,
he says.
In the event, take-up of BP's system by other companies was disappointing
and BP abandoned its sales efforts after a year, but not before attracting
custom from the likes of construction company Balfour Beatty and the US
military. "Other companies just weren't geared up to use it," says Mr
Coleman. "This is not a software package, this is a way of life." Another
reason for its failure, according to Mr Gargett at ESS, was simply that
"large multinationals wouldn't want to use the services of another."
BP was not the first big company to move in and then out of the business.
US plastics and coatings company Eastman Chemical bought Aerial Research,
a company compiling data to help companies adhere to laws on handling of
chemicals, only to sell it late last month to 3E. US defence contractor
Northrop Grumman is a counterexample, providing a system to the US
Department of Defence which it continues to support and offer to other
companies.
While the commercial incentives - and legislation such as the EU's CO2
emissions trading scheme - are creating an environment for incremental
advances, it might yet take a terrible event for many companies to invest
in state of the art technology. It is not a matter of whether such an
incident happens, but when, according to Mr Gargett. "I have been in this
business long enough to know that we will have an event of some sort."
Copyright 2004 The Financial Times Limited


Called to account: The auditing industry has yet to recover from the damage inflicted by an era of corporate scandals

The future of auditing

Called to account
Nov 18th 2004
From The Economist print edition










The auditing industry has yet to recover from the damage inflicted by an
era of corporate scandals
NO ONE becomes an auditor because the job is adventurous. In recent years,
however, the profession has been really rather racy. Auditors have been
implicated in fraud after fraud. The Enron scandal brought down Arthur
Andersen, which had been one of the profession's five giant firms. Now a
scandal at Italy's Parmalat that was uncovered in late 2003 threatens
Deloitte & Touche, another global giant, as well as Grant Thornton, an
important second-tier firm. And new scandals are still emerging: most
recently, financial manipulation was discovered at Fannie Mae, America's
quasi-governmental mortgage lender, and at Nortel Networks, a
telecoms-equipment group.
Investors depend on the integrity of the auditing profession. In its
absence, capital markets would lack a vital base of trust. So it is no
surprise that scandals have triggered changes in the profession. In
America it has seen self-regulation dissolved in favour of the Public
Company Accounting Oversight Board (PCAOB), in effect, a new regulator. It
has been deluged with new rules, restrictions and requirements as part of
the Sarbanes-Oxley act. In Europe the Eighth Company Law Directive, which,
among other things, deals with the auditing profession, is progressing,
albeit slowly, towards enactment. Britain's Office of Fair Trading is in
the midst of scrutinising its audit industry.
One consequence of all this change is that audits have become tougher. The
requirement introduced by Sarbanes-Oxley that auditors report to
independent non-executive board directors rather than company management
has reduced one overt conflict of interest. The certification of financial
reports by chief executives and chief financial officers has focused
minds. And the PCAOB has begun its inspections of audit quality and
internal controls at auditing firms. Its first, mostly reassuring, reports
were published in August.
Auditors themselves say they have toughened their standards and beefed up
internal controls. And checks-and-balances in the financial system have
been working better. Audit committees are taking their roles more
seriously and asking tougher questions of management and auditors;
activist shareholder groups, such as Calpers, are holding company auditors
to standards that are higher even than those required by law, especially
when it comes to their provision of non-audit services. Auditors even have
more business, thanks to the new rules they must implement.
Yet despite this flurry of activity, behind the scenes there is a feeling
among auditors that they are still a long way from meeting all the
challenges they face. True, there are promising solutions to, say, the
problem of conflicts of interest. But leading auditors point to one
central concern: what, if anything, can be done to reduce the industry's
alarming concentration? That problem seems almost intractable.
The world's biggest companies rely for their annual audits on a tight
oligopoly of just four accounting firms. According to the General
Accounting Office, a congressional watchdog, the ?Big Four??Deloitte &
Touche, PricewaterhouseCoopers (PWC), Ernst & Young (E&Y) and KPMG?audit
97% of all public companies in America with sales over $250m. They audit
more than 80% of public companies in Japan, two-thirds of those in Canada,
all of Britain's 100-biggest public companies and, according to
International Accounting Bulletin, they hold over 70% of the European
market by fee income.
This dominance raises two concerns. Is concentration stifling competition
and lowering the quality of audits? More alarming, if one of these firms
were to buckle, could the system cope with only a Big Three? ?The dilemma
is that these firms are too important to fail?but there are mechanisms by
which they could fail,? says Paul Danos, dean of Dartmouth College's Tuck
Business School. ?These are shaky foundations for financial markets.?
The concentration of the audit industry is a relatively new phenomenon.
Until the Great Depression, company audits were voluntary. But as part of
the Securities Acts of 1933 and 1934, listed companies were required to
disclose audited financial information to the public. The franchise was
given to the private sector, and so the auditing industry was born.
For several decades, hundreds of auditors plied their services to public
companies without much ado. A big change came in the industry in the
1970s, when rules restricting auditors from advertising and competitive
bidding were loosened, unleashing fierce competition?often on price as
much as audit quality. Around this time, audit firms began to move more
heavily into consulting, starting their transformation into
multi-disciplinary conglomerates peddling everything from legal and
strategic advisory services to the installation of computer systems.
As listed companies grew bigger and more global, audit firms did too
through a series of mergers and acquisitions. By the 1980s, eight firms
dominated the American auditing industry. By 1998, this was down to five.
After the SEC's criminal indictment of Andersen in 2002 for obstruction of
justice in the Enron fiasco, the Big Five became the Big Four.

Big, bigger, biggest
There are arguments in favour of such scale, at least where the world's
biggest companies are concerned. Unlike looser alliances of disparate
accounting firms, which find it difficult to monitor audit quality across
countries, the truly international audit firms spend piles of cash on
common training, internal inspections and the like, spreading the
substantial costs for these procedures across their relatively big capital
bases.
Also in theory, although this is perhaps more arguable in practice, big
firms can be tougher auditors because they are not overly dependent on the
profits they derive from a single client. They can also develop the
specialised expertise needed to audit increasingly complicated
clients?Citigroup and HSBC, for example, have banking activities spanning
derivatives trading to syndicated loans, spread across dozens of
jurisdictions.








The question facing the industry is how few firms would be too few? In
2003, after the implosion of Andersen, the General Accounting Office
addressed this question at the behest of a worried Congress. It found no
evidence of collusion among the top firms. Nor was there evidence that the
audit profession's concentration hurt the quality of big-company audits
(although this is an inexact exercise).
The real concern is not so much that four firms are too few, but that four
could fall to three. According to a report by Glass Lewis, a research
consultancy specialising in corporate-governance issues, Andersen's
collapse prompted approximately 1,300 firms to scramble to find new
auditors. Today the Big Four already have their hands full dealing with
the PCAOB's new rules. Cono Fusco, a partner with Grant Thornton in
America, says that a further collapse ?could cause paralysis in financial
markets?, especially if it were to occur near the end of the year when
companies file their financial reports.
More importantly, a Big Three would almost certainly be too few to ensure
an adequate degree of competition in large-company audits. As it is, some
firms are already finding it tricky to comply with the PCAOB's new rules,
which restrict the provision of certain non-audit services by auditors.
This is particularly the case because of Section 404, a new rule that
requires public companies to have their internal controls, as well as
their financial reports, checked by an independent auditor.
Take Sun Microsystems, which has annual sales of $11 billion and operates
in 100 countries. It uses KPMG, Deloitte and PWC for work on internal
controls, valuation, tax and internal audit, while E&Y is its external
auditor. Trying to juggle these relationships is a ?time-consuming pain?,
says Lynn Turner, a former SEC chief accountant who sits on Sun's audit
committee. Yet Sun is too far-flung for it to be able to appoint a
second-tier firm.
This problem is especially acute in certain industries. According to the
Public Accounting Report, an industry newsletter, the market share of
three of the Big Four firms (E&Y, KPMG and PWC) in the oil and gas
industry was 97.3% by revenue audited. In the casino industry, just two
firms (Deloitte and E&Y) audited 88.2% of the industry by the same measure
in 2004. Similar concentration exists in the air transportation, coal and
other industries.
Given this, regulators might feel constrained in how they respond to
sloppy or unscrupulous behaviour on the part of the Big Four. Almost
everyone agrees that Andersen's collapse made the financial system more
vulnerable. So far, regulators have dealt with those improprieties that
have come to light with narrow, targeted bans. For example, earlier this
year E&Y was handed a six-month ban on taking on new, listed clients. It
was found to have violated conflict-of-interest rules by forming a
business partnership with PeopleSoft, a software firm that was also one of
its audit clients. But who can say that another scandal on the same scale
as Enron or Parmalat will not surface? ?The reality is that the Big Four
is very likely too big to fail. Regulators know this?and that is a huge
moral hazard,? says Jim Cox of Duke University.

A naked option







The mountain of litigation facing the profession as a whole, and the Big
Four in particular, injects real bite into these concerns. Neil Lerner of
KPMG says there is an estimated $50 billion in claims outstanding against
the Big Four. Settlements can be enormous (see chart). And the worry is
that even the likelihood of a big payout could trigger a mass exodus of
accounting partners, followed by clients, then by more partners. ?Andersen
didn't die because of the SEC's indictment per se,? says Mr Lerner, ?but
because its international network unravelled. It was a death spiral.?
The cost of litigation and size of claims have mounted steadily over
decades, but in the post-Enron era both have ?spiked like a hockey stick,?
says Bill Parrett, boss of Deloitte in America. Some 10-20% of the Big
Four's audit revenues are routinely funnelled into litigation costs
(settlements, insurance and the like), which are then passed on to
consumers. The Big Four have huge problems getting insurance, particularly
against unpredictable ?catastrophic? risks. ?Ten years ago, there were 150
commercial insurers providing indemnity to the major auditors,? says Tom
McGrath, a senior partner at E&Y: ?Now there are ten.?
In theory, such pressure is a disciplining force on the profession. The
Big Four concede that they should pay something if they are to blame for
their part in accounting fraud. But ultimately, they argue, fraud is
perpetrated by company managers, not their auditors. Auditors claim they
bear the brunt of any financial damages sought because they have deep
pockets and are often ?the last man standing?, says Sam DiPiazza, chief
executive of PWC. In effect, auditors have become the insurers of
financial statements, writing what Mr Fusco likens to a naked (ie,
unhedged) option: ?You get unlimited exposure for a limited reward,? he
says. Critics see that as special pleading?after all, the whole point of
auditing financial statements is to give some form of guarantee that they
are credible.
But the unintended consequence of litigation run amok, argues the
profession, is that audit quality is worse. Accounting rules are
increasingly interpreted prescriptively rather than based on broad
principles that are seen as too fuzzy to hold up in court. Auditors
themselves, fearful of lawsuits, are inclined to adopt a ?check-the-box?
approach, adhering strictly to accounting rules rather than exercising
(necessarily subjective) judgment. And the looming threat of litigation,
argues the profession, hurts the recruitment and retention of the best and
brightest talent. ?Who wants to be a partner in a firm that faces billions
of dollars in lawsuits?? asks one company boss.

The cap doesn't fit
Arguably the litigation problem worsens the issue of industry
concentration, because only auditors with deep pockets can afford to take
on the risk of making a mistake with a large public company. The Big Four
point out that some European countries have caps on auditor liability. As
a consequence, they say, there is significantly less concentration in
these markets, an outcome they seem willing to contemplate. In Germany,
for example, where auditor exposure is capped at ?4m ($5.2m), 67 of the
biggest 300 listed companies are audited by firms outside the ranks of the
Big Four. In Greece, where the audit cap is set, bizarrely, at five times
the salary of the president of the Supreme Court, 27 of the 60 companies
listed on the Athens stock exchange are audited by firms outside the Big
Four.
But these arguments have failed to sway regulators in America and Britain,
where auditor-liability reform is most debated. Britain's Office of Fair
Trading recently considered and rejected auditor caps, saying that it
found little evidence that caps encouraged competition or would do
anything to reduce the risk of the collapse of a Big Four firm. Indeed,
caps might make concentration worse, since they would help the Big Four,
who are already most exposed, more than smaller outfits. As for
recruitment, figures show that, in America at least, the number of
students taking accounting courses has risen sharply since the scandals at
Enron and WorldCom were uncovered.
Can anything be done to shore up the audit profession's latent
instability? Ideally, the market would self-correct. ?Where profits are to
be made, you should find new entrants,? says Peter Wallison of the
American Enterprise Institute, a think-tank. But the barriers to entry in
the audit of the biggest companies are exceedingly high. Building huge
international networks is difficult and expensive. And legal rules in many
countries mean that audit firms have to be partnerships, so cannot raise
funds on the capital markets.
Regulation is another big barrier. The cost of doing public audits has
increased dramatically, stretching capacity thin. As an indication of
increased regulatory costs, E&Y's Mr McGrath says that so far this year,
his firm has spent nearly 400,000 man-hours on training and education on
Section 404 alone. ?Given how expensive it is to comply with the new
regulations in order to do audits of public companies, and the significant
downside from litigation, why would a smaller firm want to take this on??
asks Mr Wallison.
Even the next tier of international firms?BDO Seidman, Grant Thornton and
MRI?admit that they do not have the capacity to audit the world's biggest
companies. Nor do they feel much inclination to do so. These firms are
already thriving by auditing middle-sized firms, which, they are quick to
point out, encompass many Fortune 500 companies. BDO, for instance,
currently audits sub-Fortune 100 international companies such as Barnes &
Noble, a bookstore chain. Grant Thornton in America says its cut-off is
around the level of the companies towards the bottom of the Fortune 250
list.
Second-tier accounting firms have made some progress. According to the
International Accounting Bulletin, the eight largest mid-tier firms gained
122 clients from the Big Four in the first seven months of this year; only
nine companies went the other way. But that barely affects concentration.
Mergers among the second-tier accountants could speed things up, but a
recent General Accounting Office study found that even a merger of the
next four or five biggest firms would not create a fifth big firm that
could compete well with the Big Four.
Without a viable market solution, some wonder if more drastic action might
be needed. Mr Danos of the Tuck business school, believes that the Big
Four should be forced in some way to become six or eight firms, by
government mandate if necessary. His fear, shared by many, is that should
another Big Four firm collapse, there is a real risk that the government
would take over audits and that financial markets would suffer long-term
harm. Indeed, some say a continuation of the current state of affairs is
leading towards a creeping nationalisation of the industry. ?We have
become a highly regulated industry and this will only continue,? complains
one audit-firm boss.

Rotate and restrict
Rather than a radical move such as a break-up, some suggest that smaller
reforms could help second-tier firms grow into bigger ones over time. Mr
Cox of Duke University suggests two possibilities: mandatory rotation of
entire audits rather than the more limited rotation just of individual
partners as is now required in America; and sharp limits on the provision
of non-audit services. ?These types of changes will lead to a change in
competitive structure,? he predicts, encouraging smaller firms to develop
pockets of expertise where they can compete with the Big Four.
Others believe that caps or other restrictions on allowable market shares
for the Big Four in certain segments (especially middle-market companies)
would help the second-tier accounting firms to grow. But many second-tier
firms find the idea of restricting clients' choice unpalatable,
particularly since these restrictions would yield a viable fifth big
competitor only over many years, if at all. Auditors have been good
(perhaps too good) at helping their clients solve tricky problems. So far,
at least, their own industry's concentration looks like a challenge too
far.

Half measures
Nov 18th 2004
From The Economist print edition


The auditing industry still needs more reform









IN THE three years since accounting shenanigans at Enron first came to
light, followed quickly by accounting scams at WorldCom, Parmalat and
others, the auditing profession has been trying to sort itself out and
steer clear of trouble. But accounting scandals continue to surface?most
recently at Fannie Mae, America's giant mortgage company. More trouble may
be brewing: in the newest twist in America's unfolding insurance-company
scandal, regulators have recently launched investigations into companies'
use of certain insurance products to ?manage? earnings. Should they
unearth dodgy doings, the auditors who signed off on company accounts
could find themselves in hot water. Indeed, Deloitte & Touche, the world's
biggest audit firm, faces a lawsuit of up to $2 billion for its audit of
Fortress Re, a re-insurance firm that allegedly used certain insurance
products to inflate profits.
The continued inability of auditors to thwart accounting trickery means
that, even after the flood of reforms put in place after Enron's collapse,
the industry remains a problem. The concentration of the industry into the
?Big Four? accountancy firms?Deloitte, PricewaterhouseCoopers, Ernst &
Young and KPMG?that now audit the lion's share of the world's large,
public firms heightens these concerns (see article). Given the implosion
of Arthur Andersen, Enron's auditor and once the fifth-biggest accountancy
firm in the world, after a criminal indictment for obstruction of justice,
there is a real question about how aggressively regulators can now pursue
the surviving four big auditing firms for any future misconduct. Would the
world's financial system really be safe with just the ?Big Three? or ?Big
Two?, or even a single giant firm auditing most large corporations? That
sounds untenable.
It is all the more important, then, that the rules governing the audit
industry itself are sound. Certainly, these are in better shape today than
they were five years ago, at least in America. The Sarbanes-Oxley act
passed in the wake of the Enron and other scandals made non-executive
directors on company boards, rather than company management, responsible
for hiring and firing auditors, and created an independent oversight body
to inspect accountancy firms regularly.
Yet more still needs to be done. Accountancy firms remain riddled with
conflicts of interest. The most basic is that they are responsible for
auditing managements that, ultimately, pay them to do so. Often, auditing
relationships span decades, increasing the likelihood that familiarity
breeds over-cosy ties. And while, ideally, audit firms would compete on
the basis of reputation, so that providing the highest quality audits and
maximising profits would go hand in hand, in the real world this applies
at best imperfectly. Each of the Big Four accountancy firms and many of
the second-tier ones have been sullied by accounting scandals, yet they
continue to attract business because there are no other options,
particularly for large, international companies. The professions' shift
from a pure-audit model to a multi-disciplinary one, in which accountancy
firms provide companies with tax, advisory and other services along with
audits, only increases the potential for conflicts of interest.

Fending off future fiddles
There is no single or simple solution to the over-concentration of the
auditing industry. Nor could any regulatory changes eliminate scandals
altogether. But recent changes could be taken another step.
Sarbanes-Oxley, for example, requires the periodic rotation of the senior
partner on audit teams and bans accountancy firms from providing certain
(but not all) non-audit services to their audit clients. So why stop half
way? The goal of audit reform must be to reduce potential conflicts of
interest as much as possible. This should mean requiring the periodic
rotation of entire audit firms, and not just the audit-team leader. A ban
on the provision of all non-audit services to audit clients by the same
accounting firm should also be adopted. And European countries, most of
which lag America, should act as soon as possible to put similar rules in
place.
Such reforms could well require wide-ranging changes among the Big Four
accounting firms themselves, and might open the way to competition from
other firms for tax, advisory and other non-audit services to the world's
biggest firms. The Big Four would object. However, the rules should not be
tailored to suit them, but to serve the wider public interest and that of
shareholders. Given the critical role that auditing firms play in the
financial markets and in checking management behaviour, to do any less
would be irresponsible.



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