What’s going on in the big firms? Part III. – Complexity affects small firms too.

In my previous post, I suggested that maybe the problems affecting the big firms also affect us small firms.

I suggest that time pressures and complexity are major drivers for the issues we see in the PCAOB inspection report that found deficiencies in 12 of 52 engagements at KPMG and in 28 of 71 engagements at PwC.

Previously touched on time pressures.

On to complexity.

Here is a hint of what complexity looks like, from Francine McKenna’s post that I discussed earlier, At Deloitte, More Pain Before Any Quality Gain:

For example, how can a senior, someone with 2-4 years experience, test a complex structured derivative for potential fraud (i.e. think of the Abacus deal) which is, in reality, an embedded derivative with multiple tranches and economic and risk characteristics that may not be aligned with the host, sitting off balance sheet, after having been passed thru an SPV sponsored by a “too big to fail” bank?

The manager, senior manager, and partner typically have no idea what the subject matter expert, a member of Deloitte’s Financial Instrument Valuation Risk Analytic team, is talking about when he says the client’s models and assumptions are insufficient, outdated, or flawed. The audit team probably doesn’t even know what a synthetic CDO is.

Okay, everyone who can accurately explain what a synthetic CDO is and can explain the nuances of accounting rules of special purpose entities, please raise your hand.  Everyone on the audit team that can describe how the embedded derivative impacts valuation of the unsold tranches in deal number 3 out of 8 that went on the books this year, please raise your hand.

Any takers?  I thought not.

That complexity pressure exists in small firms.  To see how, let’s step down from Big 4 to a small local firm by scaling back the issues by a factor of 10,000.

Instead of 51,262 staff at Deloitte, let’s talk about a firm with 5 staff.

Instead of embedded derivatives in a synthetic CDO, let’s reduce that by a factor of 10,000 as well. Let’s say you just read the new loan document, which says there is a very simple interest rate swap converting a variable rate loan into fixed rate, with quarterly settlement of the difference, using published index rates in the swap.

Probably doesn’t get much easier in the derivatives world.  But you have still just moved into the derivatives world.

So, everyone in a 5 person firm that knows offhand the accounting and especially the disclosure requirements for interest rate swaps, please raise your hand. 

Any takers?  I thought not.  If we were talking about the tax treatment of the swap, one of those 5 people would know the answer.  Or could find the answer in about 2 minutes.  But we are talking about derivative disclosures.  Who pays attention to that?

Wait till you dive into the derivatives stuff in the ASC.  Haven’t looked it up, but it is probably a mere 50 or 200 pages of very dense accountantese.   The disclosures are horrible.  Enjoy researching that with the 2 hours left before you have to send the draft f/s.

So time pressures and complexity affect small firms too.

So how do we cope?

Time pressures aren’t going away.

Complexity is real and will get worse, regardless of firm size.  

How do we deal with that time pressure and complexity? 

Those are major issues for us sole practitioners as well as the 50,000 person Big 4 firms and every firm in between.  I talk about complexity and change a lot at my other blog, Outrun Change. 

You need to figure out an answer, one that works for you.  Go for it.