Corporate Governance

The Accounting Industry and the Specter of Catastrophic Risk (Part 2)

By J Robert Brown Jr.

Could another one of the Big Four disappear?  While the possibility might seem unlikely, so was the situation with Arthur Andersen back in 2002.

Arthur Andersen's reputation was certainly damaged by the accounting concerns raised about Enron.  But until the firm was indicted in March 2002, only 5% of its clients had departed.  The flood-gates opened after the indictment and continued through the conviction (which was ultimately reversed).   Following the June 2002 conviction, the firm threw in the towel and ended operations a few months later.

What is interesting about Andersen's collapse is that it was not mandated by the law.  Despite the fact that some attributed the end of Andersen's operations to the legal consequences of the conviction, this is not true.  There is nothing that requires a public auditor to go out of business following a felony conviction. 

The SEC  can put a public auditor out of business in these circumstances.  Rule 102(e)(2) allows the Commission to bar an accountant from practicing before the Agency in certain circumstances, including conviction "of a felony or a misdemeanor involving moral turpitude."  Nonetheless, this is not automatic; the SEC must initiate the process.  The Commission instituted no such proceeding in the case of Arthur Andersen. 

Arthur Andersen collapsed because, by the time the conviction arrived, its clients had largely departed (although a small percentage, under 10% remained, even after the conviction).  Some clients may have departed because of concerns over audit quality but most likely they did so for other reasons.  Some clients likely departed when their audit partner abandoned ship and moved to a new firm.

Mostly, though, clients were likely concerned that Arthur Andersen would disappear, leaving them without an auditor when the next fiscal year ended.  In short, Arthur Andersen went under because of an old fashioned run on the bank. 

Arthur Andersen demonstrated that in the right set of circumstances, including those initiated by a government action, the 5th largest accounting firm with some 2300 clients could vanish in less than a year. There is nothing that ensures this will not happen again.  It will merely take a loss of confidence in an accounting firm and fears about the firm's viability.

Does this mattter?  And, if so, what can be done about it?

Full post as published by The Race to the Bottom on December 22, 2010 (boomark / email).