quis custodiet ipsos custodes?

translation:  Who watches the watchmen?

The Comedian's Cupcake
photo credit: marceatsworld
(and if you don’t know what that’s from – read the book)

Let’s say you have a business that sells widgets. You have a warehouse and a showroom.  You hire security to watch both the warehouse and the showroom.  Your store manager forgets to lock the door to the showroom more or less every night, but he (and you) shrug it off every day since, well, there’s security there and they are supposed to verify that the doors are locked after hours.  You assume the doors are getting locked.  Then one day the store gets robbed.  The door wasn’t locked, and the security guard claimed that, well, they weren’t responsible because it’s the store manager’s job to do it.  Look, it says so in the store manual.

So what do you do? Fire the store manager, sure.  Fire security?  Probably, but at a minimum you ask them to make a few changes.  But do you give them a whopping huge new contract to also guard the warehouse?  And do you ask the same people who didn’t notice the unlocked doors to check for unlocked doors at the warehouse?

That’s what our government has done. Look at a few recently infamous corporations and their auditors:

  • AIG (PricewaterhouseCoopers)
  • Lehman Brothers (Ernst & Young)
  • Citigroup (KPMG)

The list goes on and on, but two of the “Big 4” firms are noteworthy:  PricewaterhouseCoopers (PwC) and Ernst and Young (E&Y). Why?  They won the contracts to help with the accounting for the bailout fund – the Troubled Asset Relief Program.   The government even publicly released the contracts although the names of the partners and the rates to be paid have been redacted.

I spent a long time working for the-then-Big-6, and from that experience I can state with some confidence that this is not the last time they’ll make mistakes in such dramatic fashion. Too much of the work is performed by the junior staff, working long hours auditing financial instruments that the client themselves barely understand.  Too many of the contracts are too huge for the firms to casually toss aside the client if the books are not as accurate as the auditors would like.  And my opinion is that the government realized after the collapse of Arthur Andersen in the wake of the Enron scandal that the rest of the Big 4 could not be allowed to suffer the same fate.  They are now, like so many other multinational corporations, too big to fail.

A basic foundation of trust in our markets is the concept of an independent auditor. Knowing that you can pick up financial statements that have been audited by a firm of experts and found reasonable is a powerful incentive to invest in that company.  When the auditors demonstrate – again and again – that they are unable to detect widespread weaknesses in a company, should we continue to trust them as they offer an opinion on the next company?  When will the industry fail badly enough that it, too, will not be allowed to continue?  The only alternative seems to be turning the Securities and Exchange Commission into an uber-auditor (effectively nationalizing the Big 4) but as we’ve seen the government may not be much good at the auditing game, either.  Until real accountability is assigned for the dramatic and massive failures of management AND the inability of the auditors to detect those failures, public trust in the markets will continue to erode – and nobody wants to see that.

3 comments

  • I think auditors are one of many problems, but they are definitely one of the major ones. Other big ones are the accounting system itself that gives corporations especially banks a lot of leeway to evaluate certain securities which often represent a large portion of their assets. Then you got the rating agencies who played their part in setting up an unstable system. – How do we respond? Well, with more of the same. As you say, auditing firms get the juicy government contracts. The accounting system is made more opaque since evaluation rules have been relaxed. And we still rely on the rating agencies to tell us the creditworthiness of bonds.

  • Wall street bankers, accountants, lawyers, and the politicians who need their money form a circle of incestuous relationships. Consciously or subconsciously they strive to do what the others need to have done. I don't think it will ever change until the entire Wall Street culture is destroyed. Unfortunately, Paulson is trying hard to prevent that.

  • I agree with all of your thoughts. By the way I like the picture, very cute cupcake.