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Capping Responsibility

Nov 28

Written by: Jack Ciesielski
11/28/2005 7:42 AM

Interesting article in this morning's Wall Street Journal, a maybe-phenomenon that I hadn't come across before.

The article describes an unusual disclosure in Sun Microsystems' proxy describing the "liability cap" arrangement between Sun and its auditor, Ernst & Young. The cap limits the ability of Sun to sue Ernst & Young in the event of an audit failure; as the article puts it, the audit arrangment is "subject to alternative dispute resolution procedures and an exclusion of punitive damages." It also mentions that Silicon Graphics is another liability capper.

(Know of any others? Send 'em in.)

Nothing focuses the mind more clearly than the prospect of hanging, to paraphrase Samuel Johnson. And he was right. Obviously, such an arrangement gives the auditor comfort that a single audit won't drive them into oblivion a la Arthur Andersen - and removes the prospect of hanging. The article mentions that, anecdotally at least, all of the Big Four firms have demanded them, making it impossible for some firms to find an auditor keeping all of their skin in the game.

At first blush, these are not investor-friendly arrangements; it's hard to see where taking the heat off the auditors is going to produce higher-quality audits for investors. (The only investor-friendly rationale I can manufacture is that this preserves the financial health of the auditing profession. But if they aren't concerned with the intensity of audits - how is the investor better off with a financially healthy audit profession?)

There's only one silver lining to this: for every action there's a reaction. If firms lose an avenue of reparation due to shoddy reporting, maybe they'll take more seriously their own first-line responsibility for producing high-quality financial reporting. Take the heat off the auditors, it's going to go somewhere else; this should raise the stakes for the reporting companies. That's not a bad thing. A slim straw to grasp, but a straw nevertheless.

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

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