• Keith Dalrymple

The Fate of the Russian Tsars and Securities Market Regulation

Updated: Dec 13, 2018

Georg Friedrich Hegel might have had securities market regulators on his mind when he remarked that “What experience and history teach us is that people and governments have never learned anything from history, or acted on principles deduced from it.”

Specifically, audit quality is the fundament of corporate governance and capital markets that is often overlooked until drastic changes are necessary. A recent book on the topic by the British journalist Richard Brooks “Bean Counters - The Triumph of the Accountants and How They Broke Capitalism” is unlikely to top any business book of the year charts but is a necessary read for investors, corporate executives and regulators alike.

It makes three points. First, good accounting and audit are at the core of market-based capitalism. Second, conflicts of interest, changes in legislation and industry concentration have led to weakening of audit quality that is equivalent to systemic failure. Lastly, recommendations how to fix the problem center on separating consulting from audit, breaking up of the Big Four, and nationalization of audit of the systemically important enterprises.

The first two points are hardly contestable by anyone who has paid attention to the accounting profession. The third one is a “nuclear option” that is unlikely to repair the deficiencies. Allowing for incremental, market-based solutions that are already present within the capital markets is a better way to tackle an important problem.

Following railroad boom/bust in England at the beginning of 19th century and the 1929 Crash in the United States, the importance of audited financial statements giving “full and fair” view of a company’s affairs became enshrined in laws on both side of the Atlantic. The realization that loss of trust severely interrupts the flow of capital and can bring a market system to its knees prompted the codification of audit practices.

The four firms that currently dominate the profession in an unprecedented fashion got started by exposing fraud for the benefit of investors. In 1849 London, William Welch Deloitte found the accounts of Great Western Railway lacking and forced the auditor of the company and four of its directors to resign becoming the “scourge” of railway companies. In 1890s New York, James Marwick (one of KPMG forefathers) established his reputation by calling the questionable asset values of a mortgage finance company. Like William Deloitte, Edwin Waterhouse would cut his teeth in the railways’ books.

The second half of the 20th century brought soaring markets and increasingly lucrative consulting business, fueled by the M&A boom, encouraging the audit firms to consolidate. Serious signs of systemic trouble did not surface till the mid-80s when the Savings-and-Loan crisis implicated a number of the big companies in accounting irregularities (SEC accused Charles Keating of stealing $1B).

By the mid-1990s, the accounting companies were allowed to form limited liability partnerships, which insulated the partners from personal wealth liability. Additionally, Congress exempted the accountants from certain class action lawsuits. These developments largely eliminated any negative consequences that might arise from flawed work. The legal environment facilitated the creation of the dispersed network structure of audit firms of today, where insulation of the head office and a lack of liability encourages excessive risk-taking that is at odds with the accounting mandate. Ironically, misguided legislation has wreaked the most damage, paving the way for Enron, Worldcom, Adelphia and others.

The systemic issue of audit deficiencies became apparent in the 2007 financial crisis when numerous financial institutions were given clean audits months and sometimes weeks before collapsing. The audit profession still has not taken its share of responsibility for the illegal “mark-to-fantasy” models and significant consulting fees from the failed institutions. In the US, despite the Sarbanes-Oxley restrictions and the PCAOB oversight, the Big Four still present “catastrophic risks”.

The next systemic crisis is likely to be more severe due to the growth in passive investing and private equity which further obfuscate accounting quality. The “too big to fail” premise the of audit firms will be tested again. Self-regulation and influenceable regulation have failed in similar ways. Even by PCAOB standards 30% to 50% of all inspected audits are deficient. One will be hard pressed to find another industry with similar failure rate.

As serious as the problems with contemporary auditing are, nationalization is hardly an appropriate solution. New leadership at the SEC and PCAOB have a unique opportunity to allow market forces to regulate the business. Private individuals and institutions - journalists, think tanks, corporate governance groups, whistleblowers, investment managers and investors - should be encouraged and meaningfully rewarded when their complex, important and sometimes even dangerous work helps regulators preserve auditing standards.

Across the Atlantic, a consensus for sweeping changes to the auditing industry seems to have formed. If we fail to strengthen our own checks and balances system, at least partial nationalization might be a path forced upon the audit industry. That is in nobody’s best interest. As Facebook, Monsanto and the last of the Russian Tsars have learned, if we do not make the changes, somebody else will do it for us.

Let’s go back to how it started and audit the auditors.

Written by Victoria Dalrymple

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