Re:Balance -- Jim Peterson

A Reality Check at the UK Audit Regulator: The Big Four Are Here to Stay – For Now

“If the fans don’t want to come to the ballpark, you can’t stop them.”       

Hall-of-Fame baseball player and philosopher/sage Yogi Berra

 And if the audit regulators don’t want to grasp an issue beyond their reach, you can’t stop them either.

Although, a problem postponed is not one avoided, but only kicked temporarily into the ditch.

That’s why it matters that Richard Moriarty, newly installed chief executive of Britain’s Financial Reporting Council, has accepted – as reported by the Financial Times –  that “it would not be a failure if Deloitte, EY, KPMG and PwC still audited almost all of the FTSE 100 by the end of his term.” 

In other words, quits at last for the ill-founded rhetoric, since Carillion’s collapse back in January 2018, that reductions in the Big Four’s dominant share of the large-company audit market would somehow be desirable or beneficial.

The position was blared to the skies: Labour MP Rachel Reeves, on her own and as chair of Parliament’s select Business, Energy and Industrial Strategy Committee, the Competition & Markets Authority as then led by Sir Andrew Tyrie, the FRC itself in its strategic plan of March 2018, and the Labour party’s shadow chancellor John McDonnell. 

Generously read, Moriarty’s fresh perspective can be taken for recognition that the challenges of auditor scale, geographic coverage, and distribution and accessibility of industry and other expertise – all left unaddressed by the cited critics as they kept silent on the means by which the mooted market disruptions might be accomplished - mean the end of the threats to displace the Big Four tetrapoly any time soon.

Or viewed slightly aslant, the persistent lack of political will, official energy and legislative attention to the accounting profession – manifest in the passage of nearly six years of inaction post-Carillion, and the acknowledged retreat by the government of Rishi Sunak from attempts to overhaul either the audit sector itself or its regulator – has intersected with the dawning realization that officialdom simply lacks the tools by which to re-shape the Big Four’s share of FTSE 350 audits.

In the months after Carillion’s demise, I addressed the vigorous hostility aimed at the auditors. A series of blog posts (here to here) came together in my short book, DOA: Can Big Audit Survive the UK Regulators? (Amazon 2019). There I laid out in detail the impossibility of re-distributing large company audits, whether by forced participation of smaller firms in joint engagements or in actual re-allocation of full-fledged lead auditor execution and responsibility.

In summary, the data starkly demonstrate the limits of the smaller firms – most succinctly captured in their global revenues:

• Although increasingly trailing its brethren, KPMG as it pushes toward $ 40 billion is still three times larger than BDO, at $ 13 billion the largest of the so-called “challenger” firms.

• And at $ 65 billion at the top of the table, Deloitte is some fifty to one hundred times larger than the firms implausibly included in the “challenger” roster.

My central points of four years ago were straightforward:

• “Concerns over the suitability of the Big Audit model cannot be addressed by attempted forcing of shrinkage on the large firms” (page 36).

• “Conceding the legitimacy of the concerns over audit quality, these will not be addressed by moving either clients or personnel from the Big Four to the smaller firms” (page 38).

• “The challenges of scale – geographic coverage, depth of expertise, personnel demands and financial resources – represent barriers to the emergence or creation of new players of Big Four size that are both natural and insurmountable. Those limitations – definitive on the prospects for either market share re-distribution or imposition of joint auditors with the involvement of the challengers – are no less conclusive on the question of ‘split up’” (page 49).

• “The demands of complex multi-country engagements will outstrip the capabilities of networks oriented to serve a small-country client base with limited personnel resources” (page 43).

• “The impact of scale is critical. No number of hours at the controls of a single-engine airplane can qualify its pilot, however skilled, to command a wide-body jet – much less a helicopter or a stealth drone or a space shuttle” (page 41).

• “No network smaller than the Big Four has a prayer of achieving the scale and resources to clamber into a competitive position” (page 37).

Looking back, what matters now is not the arrival of relief after years of Cassandra-like messaging, against a wall of denial, ignorance, and animus toward the Big Four. Rather, it’s what is to come. From the foreword of DOA: 

“Outbreaks of financial malfeasance and scandal are nothing new. They are both cyclical and inevitable in the operation of the capital markets – functions of the frailties and cupidity of human nature and the pendulum effects of less-than-efficient market mechanisms.”

Nor should the views here be taken as advocacy for the immunization of the Big Audit model from either criticism or the forces of change:

“The question is not whether the Big Four can survive in a form still fundamentally similar to that invented by their Victorian namesakes. It should be plain that under the combined public, regulatory and legal exposures, they cannot. The large firms have no inherent right to the preservation of their franchise in its current form – they are no more immune to the inevitable forces of evolution than were the dinosaurs or the steam locomotives.”

What deserves present recognition – although unlikely to be officially registered or acted upon – is that fresh financial scandals are gestating even now within the darker corners of the capital markets, only awaiting the conditions for their delivery. When the turn of that next predictable cycle does come, as it will with the certainty that has marked its predecessors for decades, the howls of public protest will sound as if fresh, “Where were the auditors?”

• The still-emerging impacts of the COVID pandemic and the dramatic uplift in interest rates are combining to put stresses on companies struggling to survive. They foreshadow a dramatic increase in company failures and bankruptcies, with resort by the unscrupulous to manipulations and chicanery aimed at evading reality, and with painful impact on investors and other sources of capital.

• Increasing numbers of auditor changes are the result of both adjustments of their client rosters by the larger firms and the expansionist ambitions of the smaller firms – all in the context of history’s lesson that problems in audit quality and performance are most frequently seen in the early years of a replacement auditor’s engagement.

• The current disengagement of the regulators from the basic issues will assure that the unlearned lessons available from the recent past will be sprung as if newly-invented when they befall a fresh generation of inexperienced bureaucrats.

To conclude – Richard Moriarty’s recognition of the structural imperative of the Big Four – under the current model – is a helpful and welcome step.

But there’s a basis for the emphasized qualifier. What Moriarty has achieved should not be over-stated. Critical concerns remain over both the value and the sustainability of the Big Audit model. And all the warnings remain vital and relevant.   

 

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NOCLAR: The Auditors' Impossible Task Under a PCAOB Proposal

 

"Why, sometimes I've believed as many as six impossible things before breakfast."

-- The Red Queen, Lewis Carroll's "Through the Looking Glass," 1872

As I was pleased to address today for Bloomberg, the American audit regulator is at it again:

The Public Company Accounting Oversight Board is promoting a flawed plan to escalate the responsibility of auditors for their clients’ noncompliance with laws and regulations, called NOCLAR. As proposed, the auditors’ duties would be new, expanded, and impossible to fulfill.

For context, current standards recognize that “whether an act is, in fact, illegal is a determination that is normally beyond the auditor’s professional competence.” Reflecting reality, the standards have provided since 1988 that an audit normally “does not include audit procedures specifically designed to detect illegal acts.”

The PCAOB’s draft rules would both raise the bar and obscure its height. On top of the standard for fraud detection (AS 23401), auditors would:

• “Identify the laws and regulations with which noncompliance could reasonably have a material effect”
• “Assess and respond to risks of material misstatement” caused by “noncompliance with those laws and regulations”
• “Identify whether there is information indicating noncompliance with those laws and regulations has or may have occurred”

Supporters of the proposal include PCAOB chair Erica Williams, who said, “We’ve seen far too many examples of investors getting hurt due to noncompliance with laws and regulations. And we’ve heard calls from investors for auditors to live up to their responsibilities. It’s time we answer those calls.”

The new standard “is a great step forward for auditor responsibility and empowerment, and for the protection of investors and the markets,” board member Kara Stein said.

However, opposition from corporate America and the large and small accounting firms on whom the burden will fall comprised the bulk of the now 137 comment letters posted to date. The comment period ended in August.

PCAOB member Duane DesParte, one of the two dissenters on the five-member board, said the “expanded scope raises concerns when coupled with the additional proposed requirement for auditors to ‘plan and perform procedures to identify whether there is information indicating noncompliance.’”

The lines of disagreement are drawn with a sharp and simple reason to be wary: The Big Audit model isn’t designed to meet the proposal’s expectations or to bear its consequences.

The only meaningful assessment of auditor performance is in the small number of cases that “go wrong,” with the inevitable question—"Where were the auditors?”—tested in the litigation or regulatory actions that arise with serious corporate malfeasance.

NOCLAR reporting has challenged audit practices for decades. In the courtroom, the plaintiffs’ script follows a crisp and successful template: The “audit plan” was incomplete or inadequate - the auditor’s “search” was insufficient to catch the illegality at issue - even assuming thorough planning and search, the auditors failed to identify and mitigate this particular wrongdoing.

The auditors’ defense is that as non-lawyers who aren’t trained in substance or procedure of criminal law, they were fooled by the concealed criminality of their malfeasant clients—no less than general participants in the capital markets.

DesParte flagged what would be a changed and more threatening environment: “While the proposal focuses the auditor on those ‘laws and regulations with which noncompliance could reasonably have a material effect on the financial statements,’ the filtering threshold of ‘reasonably could’ is not adequately explained in the proposal and is not addressed elsewhere in PCAOB standards.”

Under the proposed standard, the plaintiffs’ updated playbook would argue that a particular illegality or noncompliance should have been identified as material and that indicators of noncompliance that may have occurred were overlooked.

Translating DesParte’s diplomacy into the ruder language of litigation exposure - if anything, the proposed standard’s ambiguities and imprecision would mean that defense of the auditor’s work would become even more difficult, not less.

Compounding their difficulty, the auditors could expect little help from their clients’ in-house or outside counsel. The lawyers’ long-running protection of their privileged client communications (see the US Chamber of Commerce’s comment letter) enables a black hole in corporate reporting, by which the lawyers pretend to be unable to quantify their litigation and contingency assessments, while the auditors and information users pretend to believe them.

Going forward, the deserved scrutiny of the PCAOB’s proposal would compare the proposed standards with expectations under the old. A useful exercise would back-test recent examples. If the proposed standards had been in place, would there have been any difference in PwC’s audits of Colonial Bank? Or in Deloitte’s audits of Taylor Bean & Whitaker?

Those exposed illegalities may be the easy cases. What if the inquiry were more nuanced? Would KPMG’s procedures have differed in its audits of Silicon Valley Bank, where the question of legality still needs unpacking?

Or this: Verizon and AT&T recently have been sued in investor class actions over their failure to recognize the remediation costs of lead-clad cables, long since abandoned underground.

While no auditor’s risk assessment would wish exposure under both the environmental and securities laws, the auditors are flirting with the former—see the International Auditing and Assurance Standards Board’s advocacy of its proposed Global Sustainability Assurance Standard—while the scope of auditor diligence under the NOCLAR proposal is hardly likely to extend to ancient cables long buried and forgotten.

Comment letters on the proposal urged further public input, whether by task force, roundtables, or field testing. These might gracefully allow for reconsideration and retreat from the backward formulation of the PCAOB’s motivation, even as Williams contends the board’s majority is “simply making sure that the protection investors think they are getting today matches what the standard requires.”

That articulation should be concerning. A standard based on what one of the affected constituencies “thinks they’re getting” has it the wrong way around, even if the auditors are too delicate to say forthrightly, “we can’t” or too timorous to step up with “we won’t.”

For the sake of its credibility as it strives to show its value, the PCAOB should demonstrate better diligence over a proposal with potential for such dramatic unintended consequences.

 

Originally published at Bloomberg Tax Insights & Commentary, September 8, 2023, and reproduced with permission. Copyright 2023 Bloomberg Industry Group, Inc. (800-372-1033) www.bloombergindustry.com.

Alert for readers here, although too late to footnote in the Bloomberg version: on September 1, Francine McKenna provided a fulsome tour of the history of company reporting for litigation and other contingencies on her substack, The Dig -- both a helpful primer for new arrivals to the NOCLAR topic and a useful reminder for veterans of the long and tortured relationship between auditors and lawyers.    

 

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EY’s Project Everest and Stockton Rush’s Titan –- A Comparison of Two Wrecks

"The Defense Department regrets to inform you that your sons are dead because they were stupid.”

            Goose to Maverick, Top Gun, 1986

 An exam essay for my graduate-level course in Risk Management and Decision-Making, out of this spring’s two catastrophic implosions:

• Stockton Rush’s submersible Titan, crushed in a nano-second on its descent to take an expensive porthole peek at the disintegrating wreckage of the Titanic, lying 2100 fathoms deep on the floor of the North Atlantic.

• EY global chief executive Carmine DiSibio’s aborted Project Everest, by which he sought but failed to split and separate the accounting and consulting practices of the Big Four network.

Here it would be:

As an exercise in “failure study,” compare and contrast the attitudes and behaviors of Rush and DiSibio, and the sources of bias, error, mis-judgments and other factors contributing to the collapse of their ambitious aspirations.

This course seeks lessons for business, professional and personal choice-making. The semester has just ended and my terrific student cohort has scattered on their summer holidays, so here’s what I would have expected from them –- a comparative exercise in how central themes in human behavior are found and recur across a broad range of examples.

While the literature on flawed decisions is rich with guidance, it converges on the deadly combination of arrogance and ignorance. Over-confident commitment to a triumphal goal –- a visual close-up of the historic wreck site, or the cascade of riches anticipated from the EY separation –- would suppress any appeal to proceed with caution, prudence and counsel with the available expertise of others in the sector: hull design, incremental trouble-shooting, and inclusion of safety and emergency capabilities, on the Titan –- and for Everest, coherent strategic planning, globally functional leadership, and resolution of organizational inadequacies in governance and infrastructure.

Innovation, evolution and boldness of vision lie at the heart of great plans, to be sure. But not even unlimited financial resources can purchase a repeal of the inexorable laws of physics and metallurgy and marine engineering –- nor can boundless hubris and grandiosity evade or bypass the basics of economics and organizational dynamics.

The comparisons extend. The hydrostatic pressures on the hull of the Titan were calculable in terms of the water’s depth and density (P = pgh, for those interested) –- predictably catastrophic forces on a vessel of sub-optimal shape, inadequate testing, and fatigued by multiple descents.

As turns out, the formula has application, by analogy at least, to Project Everest –- the depth of its problems went unmeasured and untested, and the density of its leadership created destructive forces beyond recovery.

There’s one further comparison, grisly in its nature, in an expert engineer’s analysis:

• The Titan’s malfunction and loss of power, de-stabilizing and tipping it out of control to “fall headlong towards the seafloor,” meant that its five passengers –- helplessly piled in the nose of the cabin without lights, communications or workable emergency measures -- likely had about a minute of terrified awareness before its fatal failure.

• Likewise, the plain take-away for Carmine DiSibio in the failure of his head-to-head with EY’s American leader and deal skeptic Julie Boland was that the lights were out on Project Everest, a crash was imminent, and there was no available rescue plan or exit strategy.

Stockton Rush’s mis-adventure in “tourism porn” –- charging obscene ticket prices for a reckless project having no legitimate purpose within the protocols of real science, but induced by incentives lying elsewhere in egoism, emotion or ambition –- will be no more than a blip on the future of deep-water exploration. Further analysis is to come, but early post-mortem reporting on the recovered remains already indicates that the causes of the Titan implosion are well understood in the surfeit of flaws in its design and execution.

The same for Project Everest, and DiSibio’s frustrated conflicts as the would-be leader of a new, publicly-listed consulting enterprise. The debate will continue about the desirability of alternate models for professional services, as across the spectrum from integrated, full-service firms to “audit only” assurance practices completely separated from the expanding array of consultancies in Sustainability, cyber security, artificial intelligence and otherwise. But because history’s best example of the latter is the mixed outcome of the Arthur Andersen divorce of 2001 –- the immense success of the Accenture IPO and that company’s powerhouse growth thereafter, contrasted with the death spiral of the Andersen accounting firm in less than a year –- the next entrepreneur tempted to dive into these cold waters will be wise to study with care the uncharted hazards beneath the surface.

“What will kill you is ‘not knowing what you don’t know’” -- the maxim is captured by the academics as the Dunning-Kruger effect. Critically for lessons to be learned, any complex situation with a non-zero possibility of potentially fatal problems calls for pauses and consultation, analysis of emergent quality issues, and careful attention to dissenting views and disaffirming evidence.

Which apparently did not figure for either Rush or DiSibio –- meaning that the outcomes of both projects were fore-ordained. Titan and Everest are now reduced to rubble and mourning, for reasons traceable to the conduct and behavior of their sponsors and advocates. Further efforts in either area may benefit from their unhappy experience.   

 

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