Thursday, September 25, 2008

Conflicts and Clarity

I used to work for one of the Big 8 accounting firms, Peat, Marwick, Mitchell & Co. It was not by choice mind you. PMM had bought our management consulting firm, so I became automatically a member of PMM. While working in the Washington office, one of our senior partners from the New York office went to prison for his role in hiding from the public the true financial state of the Penn Central railroad, just before it declared bankruptcy.
I have watched now several more times where accounting partners from the firm, now KPMG, continued this apparently long-standing practice and were called on it. Apparently, the firm never learned its Penn Central lesson.
Then came the big financial shakeup, when accounting firms were chastised. The problem was, though, that they all came to the wrong conclusion. The geniuses in charge of examining accounting misdeeds somehow concluded that the problem was that accounting firms also had consulting arms and those consulting arms had created this big conflict of interest. That is, the consulting arms would step in and grab a piece of the pie, creating, they thought, a conflict of interest. So the solution was—separate the accounting firms from their consulting entities.
Excuse me??? When I worked for PMM, the accountants generally kept us at more than arms length from their clients. They ruled the roost. We were the poor country cousins whom they tolerated to live in the back bedroom.
So what is the real problem? Well, I believe strongly that the real conflict of interest is that the auditing firms, like KPMG, receive their fees from the firms they are auditing. Now that is a serious conflict of interest. It is the same conflict of interest that exists between firms that rate bonds and other financial instruments and the firms issuing those instruments. In both cases, the firms being examined can fire the audit-rating agencies if they don’t like the results.
A solution? Well, I would argue that we need an entirely new accounting approach. In this new approach, accounting firms and rating agencies would be hired, after competitive bidding by an independent federal agency to carry out the audits of major companies. The companies being audited would have no choice. They could complain if they believed the accounting practices were incorrect, but they could not simply fire the auditors. Would this create a new bureaucracy? You betcha. The federal agency could be some new government-private sector morph creature. That is a detail. Whether all companies would have to submit to this new approach, or only firms above some size is another detail that would need to be discussed and resolved.
But the key is the separation of audit firms and rating agencies from the firms being audited. The single biggest problem facing the Nation now is the absence of clear information about the financial health of the large financial firms that now threaten the very survival of the nation. No one knows the real worth of their holdings. Part of that problem is complexity. But a very large part is the active collusion of the accounting firms with these financial giants to cloud that picture. That practice must now stop.
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