When Litigation Kills the Accounting Profession-Don't Say You Weren't Warned!-GUEST POST by Jim Peterson

NOTE: While I am on vacation, I invited some guest posts from popular bloggers. Following is a guest post from Jim Peterson, a former senior in-house lawyer and partner with a then-Big Four accounting firm, and author of the blog Re:Balance. He formerly wrote a column for the International Herald Tribune and has taught MBA-level courses in risk management at business schools in the U.S. and in Paris. Jim's guest post follows.

With the devilish details of the Dodd-Frank Act now to be worked out and many special interests weighing in, legislative activity in the American financial sector returns to a standstill – probably until after the elections of November 2012.

So what would bring to the forefront a topic that to most is sleep-inducing, although it keeps some few from sleep: namely, the very viability of the large accounting firms and their fragile franchise to audit the world’s global companies?

Nothing less, presumably, than an existential shock to the stability of one of the Big Four tetrapoly – an unresolvable criminal investigation or a “bad case” outcome in one of their nightmare civil cases.

The firms are on a fortunate streak: the credit-crisis cases resolved so far are within their pain tolerance – namely, KPMG’s Countrywide settlement of $ 24 million, and its $ 44.74 million shareholder settlement and reported trustee resolution in New Century (on which, don’t miss Francine McKenna last week). And the Seidman firm has at least a temporary reprieve from its adverse $ 521 million verdict in the Bankest litigation in Miami (here).

Sadly it is not strategy, but wishfulness, to think that a further shock won’t or can’t happen, just because it hasn’t – at least since Arthur Andersen’s post-Enron disintegration in 2002. This “induction flaw” was illuminated by Nassim Nicholas Taleb in "The Black Swan" -- widely bought, and equally widely misunderstood or simply ignored.

Just as it would be naïve not to be actively concerned for another terrorist attack on American soil, or the next financial bubble already in gestation, so too the prospect of a disruptive blow to the audit market is too real to ignore. Recent bullets may have missed KPMG, but among the many loaded chambers in the game of Russian roulette are Washington Mutual (Deloitte), Glitnir Bank (PwC) and Lehman - particularly Lehman's Repo 105 transaction (Ernst & Young).

The 500 pound gorilla lurking in the room -- where lively debate really should be on-going -- is that the accounting firms’ organizations and capital structure are incapable of withstanding financial outflows greater than about $ 1 to $ 2 billion – a small fraction of the damages claimed in the largest of their big cases.

If this topic is not faced explicitly and head-on – both by the profession’s critics whose howling takes no account of its limited resources, and by its advocates whose potential “solutions” have lacked feasibility and credibility (here) – then a discussion not only goes nowhere, it doesn’t even start.

[Notes: (Jim Peterson: Under then-US Secretary Henry Paulsen, the U.S. Treasury formed an advisory committee called the Advisory Committee on the Auditing Profession (ACAP), of which I was a vigorous critic – e.g., here, here and here -- for its squandering a unique opportunity for real leadership.) (Editor (EO): See the FEI blog's most recent post relating to implementation of ACAP recommendations here which links to earlier posts on that ACAP.]

I’ve unpacked these numbers before – here and here. The chance to dust them off was reason enough to take up Edith Orenstein’s kind invitation to offer a guest post. She will join me, I am sure, in welcoming your feedback – either on my post directly on the FEI blog, or or on my own Main page at my blog, Re:Balance

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