Crusoe and msmith537, I guess I was thinking that a limited supply (Big Four audit firms) and a large demand, would tend to push up audit fees.
Perhaps two (or three) birds could be killed with one stone.
According to the Flowbark plan:
Require accountants to rotate away from their client firm every 5 years.
Somehow try to increase the number of big corporate accounting firms.
Divest consulting departments out of accounting firms. (As always, note unintended consequences.)
If the auditing fee for each client were increased by, say, 5 to 6 times the annual inflation rate for every year the client remained with the firm, while the fee at competing firms increased by (presumably) the inflation rate, that would create an incentive for clients to switch firms every 4-5 years, and might increase audit firm revenues enough to allow divestment of consulting departments. In addition, the higher revenues might entice 2nd tier firms to move up a level, thus increasing the number of big corporate accounting firms.
As for other regulatory changes, many Depression-era laws have been repealed in the past 10 to 15 years. The Glass-Steagall act comes to mind, but I’m sure that there were others. I suspect that if these were all re-enacted, there would be a significant increase in overall corporate responsibility and honesty.
If you’re talking about posters in this thread, point out why we’re ‘advocates’, please. Criticising impractical solutions to a very real problem isn’t the same as advocating the status quo.
Correct.
False. I cannot speak for executives, but auditors work in teams. The junior members do the menial ticking back to source documents; the managers arrange the approach and QA the conclusions reached. The partner manages the relationship with the client and performs overall QA on the overall audit opinion. The audit manager and partner may have a good overall view, but nobody else does. At large clients each member of the team may be at a different site looking at a different area of the statements (e.g. I’ve seen people spend weeks looking at depreciation – they don’t have the time, access or task to also look at, say, payroll expenses).
What do you propose? Violated health regulations or poor expense accounting aren’t necessarily indicators of a failing company. Sure, they might well happen there, but there are plenty of successful companies who do those kinds of things. How are individual employees in any position to turn whistleblower over something like that? The large-scale accounting fraud generally involves the deliberate application of inappropriate accounting techniques, not actual expense fraud. In other words, the big bad stuff won’t be seen by 99.99% of employees even if you gave them the actual books.
Now you’re just being silly. Criticism of a proposed solution does not equate to what you’re implying. Flowbark, Stormfield and others are also offering what (IMHO) are more realistic alternatives. Can we talk about them, instead of complaining that we’re happy with irresponsible business practices.
It would be nice. Then again, government agencies can’t pick and choose who audits them, and I doubt the fees basis works the same way. Private sector audits are seen as work that has to be done so you might as well go for the cheap option or the company that offers the best ‘relationship’. That definitely needs addressing – as I did in my earlier post.
And it seems that some of you don’t grasp how accounting fraud or auditing really works. Better auditing is required. I haven’t argued otherwise. I’ve argued that you’re trying to hold the wrong people responsible. Look to the regulators and senior management, not the ‘little people’ in the silos.
I still ike the idea of execs being tied to the profitability of the company; what I don’t like is them being tied to the stock of the company. I’ve never liked the idea of granting company stock as a means of paying workers bonus sums, or that such stocks are a benefit. Clearly a conflict of interest can manifest itself tragically.
That isn’t to say execs couldn’t just purchase the company stock on their own, and of course majority shareholders also make company decisions. That’s the way the business is framed, and though there are surely ways to help deal with this, I’m not about to broach the subject.
If a manager’s (at any level) performance is to be tied to the profitability of the company then we should tie it directly to profit. My yearly bonus check is a function of three things: the profit my company makes, my term of service, and my base salary. What else is there?
I’ve been reading so many long debates that I can’t remember if the following (I think salient) point has been mentioned: downsizing. Remeber this little gem? It was another means for managers to boost their own paychecks.
It is a clear conflict. We want CorporationA to be successful; we want to reward the managers (and workers) who make it successful. But there are unscrupulous means to create short-term success. Since the higher-ups receive the lion’s share of profitability in the first place, they stand to gain quite a bit from short-term schemes.
I am not sure how to combat all these methods and yet still create the effect of having employees which truly care to have their company succeed. flowbark has come up with a few specific remedies for the case in question, but corporate corruption spreads anywhere where decision makers realize direct or indirect profit from their decisions. A not completely improper analogy: judges which would try themselves.
Compartimentalization has paved the way for independent and largely uncontrollable decision making through what programmers would call data abstraction. But (to strain this analogy more) the operating system still holds all the processes in check, and retains the ability to do what it wants.
In the corporation we have, deliberately or not, attempted to insert a little democracy into its functioning. And we find that those who can vote are voting themselves rich (little O’Rourke reference there).
The point of this exposition isn’t to say we shouldn’t combat corruption: we should. But it is a losing game. What I think we need to focus on the most is lessening the ability for the corporate voters (analogy-wise) to reward themselves, and to soften the blow of unintended corruption.
It is not the hope of government to eliminate all crime; theives will always be present. But through an effective police force (capturing after-the-fact) and a reasonable insurance system (softening the blow) we can eliminate theivery as a concern in everyday living.
Now: how do we do that?
[ol][li]Only a worker’s revolution can yada yada. Blah blah.[]Modify GAAP so that stock options grants show up in the income statement and thereby affect reported earnings. Again, I would rather eliminate stock options entirely. Make everyone go through brokers like the rest of the world with the money they earn.[]Require accountants to rotate away from their client firm every 5 years. Unfortunately, accounting isn’t even in my armchair’s reach (and I’ve got a rather large armchair!). Knowing you to be a reasonable fellow I will accept that it is actually feasible to switch firms without problems like “new firm has to learn about the company” et cetera. Given that such switching can be done, is five years too long, too short, or just right? How long does a thing like an accounting scam need to run before people can profit from it? I fear this is a solution that won’t really do anything. Can you allievate that fear?[/li][li]Somehow try to increase the number of big corporate accounting firms. Indeed. This is more of a 3a IMO. Not only that, but changing firms isn’t quite as important as changing those who handle the account. Switching from firm A to firm B isn’t doing anything if some of the important accountants also switch firms… especially with corporation A handling on their resume. Is this a realistic concern?- because, again, accounting-specific info is way out of my understanding.[/li][li]Not sure what this means.[/li][li]Not sure what this means.[/li][li]Incentive stock options are the problem Hell yes, though I would (as noted) go further than you to completely disengage handing out stock for salary or bonuses at all. If you want company stock, go buy it on the market. Period. (exceptions being mergers, etc)[/li][li]Do something clever with the compensation scheme. Well, as can be seen from my above exposition this is where I think the real deal lies. Both compensation and corporate structure need to be reevaluated, and done so simultaneously.[/li]Strengthen shareholder oversight. I’m not certain this will avoid the “voter apathy” effect. First, major shareholders already have a vested interest in keeping the company profitable. The notion of “profitability” is what is under attack here. Or am I not understanding your intent?[/ol]Apart from my snotty McDonald’s remarks, I hope I have added something here besides a means to combat my own ignorance about the events and discussions at hand.
Re (3) and (4): the idea of (3) is that it prevent cozy relationships calling auditor independence into question [since auditors report in theory to shareholders, rather than getting comfy with directors to flog more consulting]. The downside is, as erislover points out, the learning curve. I support the idea, but there is a risk that a new firm won’t have time to learn the legitimate intricacies of a company’s account in time and will therefore be less likely to spot the most complex frauds.
Re (4): I imagine the problem of staff switching could be stopped quite easily through regulatory requirements. As it is there are certain restrictions on my joining another Big Four firm within six months, so I doubt extending that to ensure staff cannot work on clients for more than the firm’s tenure as auditor could be required.
I’m more concerned as to how you force the creation of new firms. Firstly, in the practicalities of ‘forcing’ it, and secondly in terms of staffing: half the people who join will come from other Big Four firms and it might just create an identical firm, effectively.
I agree with the general direction of the measures for change you’re suggesting.
I’m suggesting more activity on two fronts: individual responsibility, and prying, hostile audits.
The United States is a nation where individuals routinely vote on complex issues, and accept responsibility for results. Where direct voting leaves off, representative democracy takes up. Then individuals vote for proxies who have responsibility in their place. I’m suggesting an employee advocate who acts independently of senior managers, who collects complaints and comments, investigates them, and makes the results available (at least to the board of directors–somebody who WILL take responsiblity).
While stealing a trip to Paris isn’t in the same league as the Enron fraud, it’s a matter of degree. “Faithful in small things, faithful in large.” I’ve met a fair number of managers who would steal anything they could get away with. (In fact, one of my managers did go to jail.) If they aren’t made responsible for stealing a trip to Paris (a felony, if it was rated as a civil crime, I was realizing), there’s no disincentive to try something bigger.
The managers who cheat on a large scale, just like someone cheating on their income tax, understands the rules, and seeks to avoid them. Better auditing, such as Bush was suggesting yesterday, might stop certain kinds of fraud, but as long as an accounting firm is “going down a checklist” (as someone was saying on PBS last night) major fraud is still going to occur. There needs to be something more creative than that.
I don’t know how companies set up relationships with auditing agencies, but if it’s on the basis of who’s cheapest, as you suggested, then the need for a hostile, independent auditor seems pressing. Who would pay? There are several possibilities, the ones that seem most practical are: the government, and (heh, heh, heh) a company’s competition. I’m Shell Oil, would I like to pay $1,000,000 a year to fund an audit of British Petroleum? (even though they only report to the company’s own board?) YES, PLEASE!
Crusoe said, “Regarding auditor rotation, I think that 4-5 years isn’t necessarily a short enough interval; the audit firms would be angling for ways to make more money from the relationship even with that in mind.”
Hm. Ok, then block the accounting firm’s ability to take a consulting contract while they check the firms books, and 12-18 months afterwards. (These rules could be extended to individual accountants as well, although I might make them more lenient for them to avoid locking them to their firm).
To further focus matters, permit me to list the following:
Preliminary Observations
None of the 10 or so odd cases of fraud were detected by law firms undertaking class action suits. (This may be due to the gutting of these laws in the 1990s by the Republican Congress. More likely, (WAG alert!) the class action mechanism isn’t especially effective in uncovering this sort of malfeasance. )
As noted in this thread, the fact that GAAP measures of earnings have diverged from the BEA’s earnings measure by 40% suggests that we are not talking about a few bad apples. (Oh, btw, if the financial press is now so aggressive, why is the “few bad apples” claim taken seriously at all?)
Massive Conflicts of interest exist within the US’s capitalist system
Investment banks employing so-called stock analysts make little money directly from this service. As a result, the departments have become little more than a marketing wings of their underwriting and deal-making branch.
CEOs often serve as Chairmen of their Board of Directors. This is actually hilarious: they don’t even pretend that the Board is providing independent oversight of management.
My understanding is that most Board members are paid a fairly small stipend. I’m not aware of anyone who truly makes their living as a professional director, who in flowbark’s fantasy world might represent a large pension fund or institution. (eg a Calpers).
Audit firms have decided that they can’t make any money auditing: consulting, you see, is just too dang profitable.
Further Problems
5) Executives publish phony numbers, enrich themselves with stock options, and sell out before their firms go down in flames.
Even in less egregious cases, (and most cases are “less egregious”), there still appears to be rampant manipulation of earnings.
Prompt disclosure of stock & option sales. All sales pre-announced.
Tough medicine (Though less tough than Eris).
a) Require all compensation to be booked immediately as costs.
b) Take the existing $1 million cap on compensation. Increase it to, um, $5 million and drastically narrow the scope of the “incentive loophole”.
Details: My understanding is that if a company pays an executive more that $1 million annually, the excess cannot be deducted on the company’s taxes UNLESS the excess is an “incentive payment”, in practice a stock option.
Flowbark plan: “Incentive payments” MUST consist of non-transferable call options (options to BUY the stock at a given price (say, zero dollars)) that can be exercised ONLY 18 months or more AFTER the executive retires. That is, tax-deductible incentive payments MUST be tied to the long-run stock price.
Furthermore, the executive will not be able to sell the option to somebody else (or rather, the buyer won’t be able to do anything with that option.) The executive, however, may use the option as collateral for a bank loan.
Ban sweetheart loans to executives. (This is slightly tricky to implement actually: GE, for example, owns a credit union that services its employees.)
Implement Flowbark’s Plan 9. As far as I can tell, institutional shareholders other than Calpers don’t put a great deal of thought into how they should vote their proxies. If they don’t like a company, most of them figure correctly that they should simply sell the stock. At the same time, I suspect that they would be willing to listen to good counsel if it was free (at the margin).
Put the auditors back in the audit business.
a) Rule 1: You can consult for a client. You can audit a client. But you can’t do both at the same time. Or nearly the same time.
b) Rule 2: You can’t get too cosy with your audit client. (There’s a bill in Congress mandating 4 year turnover. I honestly don’t know what the optimal time period is.)
c) Fewer audit firms will lower competition. This will tend to drive up fees, making the business more profitable. Note contrast with original recommendation. Tradeoffs, tradeoffs, tradeoffs.
Support the Sarbanes bill, which establishes an oversight group to regulate the auditors. Or state publicly why this is a bad idea (Hint: GWB). www.restorethetrust.com
Partly_warmer: I quite like the idea of an employee representative, but I’m not sure how to guarantee their own independence. Maybe have a government-appointed individual from a public sector ‘pool’?
Sorry – I didn’t mean to sound dismissive of the other suggestions, but I’m at work and don’t have time to read up on the pros and cons of them (I’m no expert on loans, share options or the like).
I have a suggestion which may not be smart at all, but from what I understand IRS statements and audits for public releases and so on are two seperate balls of wax. Is that right?
If that’s right, that seems stupid. If a company is going to claim profits, they should pay taxes on it. Why not just go off tax submission forms?
Y’know what sucks? Having weeks of business travel such that you can only pop in on the SDMB once a week or so…especially when a topic, like this one, that you’re interested in pops up. That’s my way of saying both “sorry for the belated comments” and “you shouldn’t hold your breath waiting for replies.” :mad:
Anyway, flowbark made a few suggestions that have made me want to throw my shoes at the TV in my hotel room the past couple of months. Specifically:
The only people who suggest this and think it’s meaningful are people who never bothered to look at a company’s financial statements. A company that does not expense options directly in its income statement is required to disclose what its income would have been in had it expensed the options in the footnotes to its financial statements. In other words, the information is right under the nose of any investor who bothers to look for it. It is clearly labeled, in tabular format. It’s actually kind of hard to miss.
And yes, it requires an investor to actually read the footnotes instead of putting the data front and center. It requires a little work. But let’s face it: any investor who does not read the footnotes to a company’s financial statements does not understand the financial position of the company. All kinds of things are disclosed in the footnotes – important accounting assumptions, certain lawsuits, key tax information, investment holdings, etc, etc, etc. If you think you can get the whole picture from a one-page income statement and a two-page balance sheet, think again.
The only reason there isn’t much opposition to this reform (skittish tech companies notwithstanding) is that it’s meaningless: analysts and investors can simply back out the options figures if they want to see the financial results sans option expense. Instead of giving investors both sets of figures, you’re forcing them to pull out their calculators to get the option-free bottom line. I think you’re actually reducing the quality of disclosure by implementing this “reform.”
Companies back it because it gives them cover from more meaningful reform measures. A better answer to the option issue would be investor education – beginning with the lesson to read the darned footnotes.
Written by someone who clearly has no idea about audit costs. When a company changes auditors, the new auditors have to satisfy themselves that not only the current year, but the past two years’ financials were accurate. It essentially trebles the work. That means that company employees will be distracted from productive work three times more than they would be from a regular annual audit.
Won’t happen. To audit a large, public company requires a certain critical mass of manpower. There’s a reason the Big 12 became the Big 8, then the Big 6, then the Big 5 (the cut to Big 4 was clearly for, ahem, other reasons).
My wife (full disclosure: I married a Big 4 auditor) will cite you chapter and verse as to how complementary audit and consulting services actually improve the quality of the audit services a company recieves.
The real issue here seems to be “the firms make a lot of money from consulting, and that cash conflicts with the auditor’s ability to be independent.” But let’s face it: that conflict remains even witha total divestiture of consulting functions; audit fees are, after all, paid by the audited client. And audit fees are nothing to sneeze at.
Let’s say that AA didn’t provide consulting services to Enron. They still pulled in millions from the audit function. If you were the AA partner in charge of Enron, you would be risking your career if Enron were to go to another firm. You would still feel immense pressure to cave to Enron’s audit demands. I’d be willing to bet that AA would have still given Enron everything it wanted even if they didn’t provide consulting services.
Until you figure out a way to prevent clients from footing the bill for audits (and I’ve heard some interesting proposals in this regard, including one that would create “audit insurance”), this problem will persist, consulting fees or no.
Congratulations, you’ve just killed the tech industry. Plus, as a shareholder, I want management’s interests to be aligned with mine. A good way to do that is to give them options. I don’t want them to commit fraud, of course, but let’s not throw out the baby with the bathwater.
We have such oversight councils: they are called “boards of directors.” They have a duty of care to the corporation to exercise diligent oversight over company affairs. Failure to do so can mean a nice fat shareholder’s derivative suit (which is why D&O insurance is so damned expensive).
The Board is ostensibly elected annually by the shareholders. True, in widely-held public companies, company management has a ton of influence over who sits on those boards. But your proposal doesn’t address how your councils would be staffed. The simple fact is, management will always have a lot of influence for the simple reason that they are by definition running the show on a day-to-day basis.
(I assume you seriously meant shareholder oversight, meaning oversight run by the shareholders. If it’s a government thing you’re proposing, then you’ll have government oversight, a very different thing. We already have a measure of such oversight in the form of the SEC. Good luck staffing the SEC with enough bodies to oversee every single publicly traded company in the country.)
Dewey Cheatem Undhow(DCU): Thanks for the feedback. Let me note the following before I address some of your specific concerns.
This thread was originally intended to list and critique a variety of corporate reform methods. I am not necessarily attached to any of the items in the above list.
While I trust that there are costs to strengthening oversight, there are also benefits. Specifically, as I noted in this thread, US auditors stopped doing their job in 1998.[1] It was in that year that GAAP estimates of profits and profit measures from the GNP accounts began to diverge. In 2001 the gap topped $100 billion dollars, indicating that GAAP profits are overstated by over 40%.
Since the malfeasance is not evenly spread across the S&P 500, this makes comparing the true profitability of companies difficult. It also implies that the earnings growth rates over past few years are bunk.
This matters.
Those who examine at the footnotes of a given firm nonetheless have no basis for estimating the true profitability of the relevant industry. There is simply no data to form a basis for this sort of comparison.
Worldcom shows us the effects of phony numbers: too many resources flow to incompetent lying managers as their stock price is bid up. Worse, their competitors start to make foolish decisions, as they wonder why nothing seems to work in their company.
An hilarious anecdote: it was conventional wisdom that internet traffic doubled every 100 days. This little scrap of evidence was eventually traced to Worldcom. It turns out that traffic actually doubled every year: it was capacity that doubled every 100 days (or 1000% per year). This is a massive amount of overinvestment underwritten by misinformation.
Part of the genius of capitalism is that enables scarce savings to flow to the most profitable activities. This exercise involves a lot of difficult forecasting; nontransparent accounts make this job more difficult and undermine efficient resource allocation, to the detriment of economic growth. Overinvestment in internet capacity (but not SDMB server capacity ) is but a single visible manifestation of this. There are presumably a multitude of more pernicious examples.
[1] Some commentary by DCU’s close associate on changes in accounting standards over the past 5 years would be interesting.
Hey, a Brit in this thread advocated rotation every single year. Furthermore, Congressional proposals call for rotation every 4 years.
Somehow, the fact that a company’s books have to be checked by 2 audit firms half of the time (or less, in my example) doesn’t bother me. Sure, it’s expensive. But so is massive overinvestment.
Divest consulting departments out of accounting firms, etc.
To your objection, I may add the argument that it may be difficult to attract good people to the accounting biz if they are not allowed to engage in more interesting consulting work. (I may also note that it is not clear to me where to draw the line here. If an auditor recommends and manages a switch to LIFO inventory accounting is that consulting?)
The Economist has noted the assertion that accounting consultants can tip auditors off to potential irregularities in the accounts.
Incentive stock options
As revealed in Managerial Power and Rent Extraction in the Design of Executive Compensation, shows that the structure of existing stock option contracts do not “maximize shareholder value”: rather they are written to indulge in the avarice of management. As a shareholder, you have apparently been hoodwinked. Eris’s proposal to shift to straight stock grants might be noted here.
On killing the tech industry by placing a soft cap on compensation over $1 million:
CITE?
Strengthening corporate governance and shareholder oversight
We both know that Boards of Directors are basically self-perpetuating organizations that are almost always selected via Soviet-style “approval” elections. Furthermore, we have evidence of massive oversight failure, the lawsuit mechanism notwithstanding.
I did not say that we should appoint 6000 advisory councils, for gosh sakes. I was thinking of 1-5. They would be research operations that would issue comments on proxies (and Board elections). As the pension funds and other institutional shareholders would be their customers, they would be the ones that “directed fees to their favorite(s)”.
The organizations could be for profit, nonprofit or not-for-profit. May the best organization(s) receive funding.
Put it another way. Analysis of these proxies are public goods. The big shareholders would get together and form a trade group or guild to fund this analysis, which would be made public. This is a pretty low-key suggestion, but it would involve mandatory (though modest) fee assessment. Sort of like the FASB or Dairy Council, (except for a quasi-public purpose in the case of the latter.)
The problem stems in part from power and priviledge corrupting, sooner or later, so power and priviledge need to be shared. To have tens of thousands of employees and shareholders relying on a company that has a hierarchy of centralised decision making, where individuals are not held accountable for their actions, is foolish. I believe treating companies as individuals under law is a massive mistake, it allows (perhaps intentionally so) individuals to hide behind a company name and avoid being held responcible for their actions. However there are some aspects of law that do not seem to treat companies as they do individuals. For example my father was at one stage earning enough from his practise to be taxed (in Australia) about half of his income, have you EVER heard of a company paying the equivent? Proportionally, I payed more tax in a year working on a forklift then some of the wealthist Australians have paid in recent decades.
The corruption is only a symptom of a system of greed and economic rationalism/fundamentalism. Dispite the claims of virture by our governments, the power within our democracies is so centralised (perhaps less then in the past, but still more then is democratic) that those on top of politics can not possibly represent the bulk of their constituency. Instead these politicains are receptive to the proposals of those rallying them, corporations and the wealthier pressure groups. Thus radical change to the very nature of our economies and governence is required in order to protect workers and families from the ruthless and parasitic capitalist minority.
) is but a single visible manifestation of this. There are presumably a multitude of more pernicious examples.