How quickly time does fly. It’s been three long years since my last review of the litigation “tipping point” that would disintegrate the fragile business models of the Big Four accounting networks.
It’s time again. And not just because of the regulators’ threatened imposition of mandatory auditor rotation and other limitations sure to impair the quality of audits -- both PCAOB Chairman James Doty and EU markets commissioner Michel Barnier (see his November 30 press release, FAQ’s and provisional directive).
Those worrying about the incomprehensibility of Barnier’s financial and market thresholds for splitting off the non-audit practices of the European networks or injecting second-firm auditors (here) are looking in the wrong place.
That’s because the inventory of multi-billion dollar financial scandals in the firms’ client lists is constantly refreshed: revelations this fall alone include Kweku Adoboli’s roguish trading at UBS, the $1.2 billion shortfall in customer accounts at MF Global, and the decades of under-performance at Olympus concealed by dubious advisors’ fees.
Back in September 2006 – to re-set, and for new readers -- a report by the consulting firm London Economics to then-EU markets commissioner Charlie McCreevy (here) modeled the threshold limits of financial pain that would be tolerable to a Big Four UK partnership, before its owners would withdraw their loyalty and their capital and vote with their feet – a process that would, unfortunately, lead to the rapid disintegration of the entire franchise of privately-provided assurance to the world’s large public companies.
I applied the London methodology to the global financial results published by the Big Four, in December 2006 and again in October 2008 – yielding calculations that, however ominous, were never disputed, nor have they been displaced by alternate models or methods.
It is poorly appreciated, if at all, that the private partnerships comprising the large international accounting networks operate with razor-thin levels of capital, for three reasons:
- Their major working capital needs – employee salaries, space costs and technology and methodology investments – are financed out of the fire-hose cash stream of client-derived revenues.
- The tax codes of the largest economies are cash-based for partnerships, creating a powerful incentive for the firms to distribute current income out to the partners to match with their tax liabilities.
- And, there being no alternatively valuable need or opportunity for the deployment of excess capital under the firms’ current business models, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding pens.
Latest available figures for the Big Four indicate total annual global revenues of some $ 102 billion.
Applied to those figures, the model indicates that the break-up threshold for any one of the Big Four firm’s litigation “worst-cases” would be in the range from a maximum of $ 6 billion down to $ 2.2 billion, if viewed at the global level.
That is a considerable increase from the earlier numbers, owing to the great leap in total big-firm revenues in the intervening years.
But cautions remain. Most importantly, cohesion of the international networks under the strain of death-threat litigation, or the extended availability of collegial cross-border financial support, cannot be assumed. Arthur Andersen’s rapid disintegration in 2002 with the flight of its non-US member firms is illustrative.
So it is necessary to look at the bust-up range based on figures alone from the Americas, the most hazardous region. If left to their local resources, as was Andersen’s US firm, the disintegration range shrinks, from a maximum of less than $ 3 billion down to a truly frightening $ 675 million.
Amounts at that level compare ominously with the litigation settlements recently extracted from the larger debacles of the last decade – examples led by Bank of America’s post-Countrywide mortgage-securities settlement of $8.5 billion (here) and including such investor settlements as Enron ($7.2 billion), WorldCom ($6.2 billion) and Tyco ($3.2 billion) (here).
But those amounts were only available because inflicted on the investor-funded balance sheets of the corporations contributing to the settlements – resources not available to the private accounting partnerships. And they are even more darkly comparable with the exposures looming in the pending claims inventory.
True, in recent months the large accounting firms have enjoyed remarkable success in disposing of large litigations for modest sums – examples include KPMG resolving Countrywide for $ 24 million (here) and New Century for $ 45 million (here), and Deloitte settling Washington Mutual for $ 18.5 million (here).
However, hope for the indefinite continuation of such forbearance on the part of the plaintiffs is not a strategy, but only a wish.
As the catastrophic impact of “black swan” events makes clear, it only takes one. And at that tipping point, all the marginal fiddling by Barnier, Doty and their ilk becomes academic.
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 To summarize the model, as I wrote previously, “The original London study assumed that, in a highly-charged crisis environment dominated by the pressure and publicity of a massive adverse litigation result, critical numbers of partners would defect, so as to put a firm into a death spiral, if faced with a profit reduction of from 15 to 20 percent and extending over three or four years.”
Ernst & Young, as of June 30, 2011: Global revenue $ 22.9, Americas $ 8.9 (here).
KPMG, as of September 30, 2010: Global revenue $ 20.6, Americas $ 6.4 (here).
PwC, as of June 30, 2011: Global revenue $ 29.2, Americas $14.1 (here).