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Seeking Special Protection

March 9th, 2007

We all know about Arthur Anderson, the big accounting firm that went down with Enron in 2002. Suddenly we went from having “The Big Five” accounting firms to “The Big Four.” See, the Federal Securities & Exchange Commission (SEC) imposes pretty significant reporting requirements on any publically traded firms. Both before and after the adoption of Sarbanse-Oxly, many of these reporting requirements can only be fulfilled by an outside accounting firm. The large companies rely exclusively on the Big Four to fullfill their outside auditing needs.

But, did you know that before there was The Big Five there was The Big Eight? Presumably there was also the Big 12 and the Not Quite as Big 17. The accounting business, like so many businesses, have been seeking efficiency through mergers since the 70’s. Taking smaller companies and merging them into successively larger companies. So imagine my surprise when I read in the Washington Post today that these same companies are seeking legislative protection from liability because, and I quote, “We just don’t want to be put out of business.”

There tactic here is classic. Since they provide such a valuable and necessary service, they will argue that it is better, for society as a whole, if they are essentially immune from suit so as to ensure the few of them that remain continue to function. It would be worse, they will say, for there to be only three or two firms than for one of them to engage in fraud and get off the hook. It’s the same argument the airlines make when they get huge federal bailouts.

The critical difference between airlines and accounting firms is that there is only so much market capacity for airlines. Given the huge capital resources needed to run airlines, terminals, ticketing, etc, it is safe to conclude that there is an optimal number of airlines and that it is a relatively small number. But the accounting firms only real capital cost is in brain power. The more clients they have, the more brains they need to employ. My guess is the whole thing scales rather well… which is why they merged together in the first place. If there is no lost efficiency from merging two firms, both with 50 employees into a single firm with 100 employees (maybe less), then you’re going to do it on the grounds of eliminating competition. It’s a no brainer (excuse the pun).

I consider this classic short term profit driven thinking. One of the central principles of computing, especially network computing, is to reduce the number of single points of failure. You never want a system to rely on one part which, should it fail, the entire system will go down. The same principle applies to civilization. You don’t want everyone employed in the same job, you don’t want your food source to be in one location, you don’t want all your energy to come from the same kind of fuel. The more you diversify the better prepared we are for unforeseen, yet inevitable, changes in circumstances. It’s the same principle behind a diversified stock portfolio.

Yet everytime one of these accounting firms merged together, we got closer and closer to a single point of failure. Now the four firms are so huge and have such an iron grip on the market that it is near impossible for a new market entry. The public traded companies have no choice but to hire one of the Big Four, and thus no medium sized accounting firm can ever become Big #5. Now the possibility of a bankruptcy due to a civil lawsuit is a big deal… the investment system needs these firms to survive, regardless of the cost.

Which brings me the final thought of who, exactly, bears these costs? See, when there is fraud, and that fraud is aided by an accounting firm, the investors have civil recourse to recover lost funds. When a company goes bankrupt, like Enron did, there’s not a lot of money available to make those investors whole. To be clear, “investor” should conjure up both thoughts of already rich billions as well as the middle class saving for their kid’s college and industrial workers pensions (the stock market, it’s not just for elite any more!). If the purpose of the civil justice system is to make those damaged whole again, then going after an accounting firm who helped perpetrate the fraud just makes sense. If the SEC, or Congress, goes along with the Big Four’s wishes, don’t think those unrecoverable damages just go away. Instead, all those damages felt by the collapse of a public company will be carried by investors, while the accountants who both aided and likely benefited by the fraud, will continue to operate without any punishment or financial loss. Talk about a single point of failure.

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