The Financial Times ran the story on May 16. In particular, the reporters claimed that KPMG and PwC were evaluating whether to enter the world of credit rating, even quoting John Griffith Jones from KPMG that the firm was in fact “passively considering it.” PwC’s Richard Sexton added that CPA firms were always looking for ways to grow their business.
My first reaction was obvious—wouldn’t this relationship create a conflict of interest? The auditor examines the accounting reports and attests the assertions by management contained in those reports. A credit rating agency takes the quantitative and qualitative disclosures in the accounting reports—and other information—and evaluates the entity’s ability to repay the credit obligations on a timely basis. An enterprise that engaged in both tasks might be pulled to give a thumbs up for some accounting shenanigan to assure it received the fees of both audit and credit rating activities, rationalizing that it could always downgrade the firm’s rating.
If you think such rationalization is impossible, consider the strategic decisions made by Arthur Andersen in their Waste Management audit, as well as some of the others. To his credit, Mr. Jones acknowledged these conflicts of interest.
Let’s also review the structure of the audit process and the credit rating evaluation process. The audit firm is paid by the firm it audits. In today’s world, the credit rater is paid by the company it evaluates. Before the 1970s, this was not true; in fact, today’s conflicts of interest were avoided when rating agencies made their money by selling the information to investors. (See my essays on the performance of credit raters and on the SEC study of credit rating agencies.)
Notice that both business models are the same: revenues come from the party being evaluated. While neither structure is ideal, the audit process works as well as it does because securities laws allow aggrieved investors to sue auditors if it appears the auditor did not perform an adequate job. It isn’t perfect, but at least these disincentives help align the interests of auditors with the interests of the investment community.
This observation does not apply to credit rating agencies. While credit raters have been sued by a variety of investors, the courts, like Teflon, are not allowing the lawsuits to stick. I am not a lawyer so I remain confused by these contusions, but we know the consequences. If there are no disincentives for overly optimistic ratings, soon everybody will be AAA.
Congress has been muddling over how to improve the results by credit raters and have been considering the rotation of credit rating agencies and their assignment to corporations on a random basis by some government agency. A more direct improvement would come if Congress would just open the door to trial attorneys.
On second thought, I might be less bothered about an accounting firm’s performing credit rating analyses if it agrees to open itself up to the courts when it screws up. We cannot expect flawlessness by credit raters, whether it is Fitch, S&P, Moody’s, KPMG, or PwC, but we can demand competence, objectivity, and independence.
An interesting sentence in the Financial Times article is: “Mr. Griffith Jones believes auditors should give more of a subjective opinion about the companies they control to give investors not just ‘a set of backward-looking numbers’ but also some idea of the risks in a business.” Never mind that that is supposed to be the purpose of 10-K Item 1A. The concept of an audit being more forward-looking is interesting and provocative. If the profession ever moves in that direction, there indeed would be little distance between what auditors and credit raters do.
