Re:Balance -- Jim Peterson

The Endangered State of EY's Split-Up Strategy

As I am pleased to discuss today as a guest on Francine McKenna's substack, The Dig -- whether or not EY actually does split, there are big implications for capital markets and professional service providers.

 

#1 on Billboard’s Hot 100, August 1962

 

Nine months on since last May’s revelation of EY’s plans to break up its audit and consulting practices into AssureCo and NewCo, freshly reported opposition from its US leadership has thrown the entire project into disarray.

Ernst & Young has paused its plan to spin off its consulting arm, bowing to pressure from its U.S. partners to rethink how the tax practice will be divided when the firm is split into two, according to people familiar with the matter.

As I put it in August, global CEO Carmine Di Sibio’s Project Everest looks increasingly to be “a hill too steep to climb.”

Allocation of the firm’s tax practices is said to be the sticking point, with the Financial Times reporting “‘chaos’, ‘low morale’ and ‘infighting’ at the firm,” while both deal details and the necessary country-level partner voting have continued to slide. 

As fully unpicked in this weekend’s Financial Times, outstanding uncertainties include:

• Resolution as to which of the 150-plus country practices and who among the thousands of employees will participate.

• Resolving whether to cut retired partners into the expected pay-outs.

• Allocation of legal liabilities, notably for the overhanging large litigations.

• Reduced value for the mooted IPO of a newly-created consulting enterprise.

• Fundamental challenges to raise necessary capital and achieve handsomely-projected growth rates.

• Persuading both existing and prospective clients of the ability of the bifurcated businesses to be competitive for value and quality.      

Large-country partner votes have slipped from last November, reportedly to April, but with the latest news suggesting they are now delayed indefinitely. NewCo’s IPO still aspires for late this year or perhaps now into 2024.

It’s an understatement that grounds for skepticism about Project Everest persist. Irrespective, there remains a serious concern -- namely, the very stability of Big Audit itself — the franchise by which the four networks that survived the collapse of Arthur Andersen in 2002 emerged to dominate the provision of audits for the world’s largest public companies.

Whatever its outcome, succeed or fail, the very launch of Project Everest has put EY’s structure and stability in play. Either way, that presents an existential threat to Big Audit, under the inevitable degrading of EY’s capability, because the survival of the Big Audit model itself depends on the continued health of the entire quartet of providers. Its number cannot realistically be reduced below its current critical limit. 

Suppose the Proposal Fails

For whichever among the lengthy list of possible reasons, there will be an inevitable burst of snarky criticisms. There will be time enough to savor the business school case studies written about a deal conceived in weakness and bungled in execution. Rather, if the audit partners were forced to remain in hostile cohabitation with the disappointed consultants whose lofty NewCo aspirations failed to materialize, consider the state of AssureCo’s internal morale, mutuality of commitment, and operational dislocations.

Carmine Di Sibio’s days would be numbered. He and his team would be fatally wounded as leaders, and the replacement process would be immediate. At best an uneasy peace might hold, while the process unfolds.

With the deflation of their rainbow-tinged expectations, the consultants would be disgruntled. Many would be inspired to pursue smaller, achievable niche transactions, and it would be open season for poaching. (The Financial Times report that PwC has a target of up to 500 EY partners in the US reflects the atmosphere; Alvarez & Marsal has announced its appetite and has already picked up a large practice group from EY China.) 

On top of the need to massage uneasy clients, the environment in the audit practice would be fraught. The energy sucked away by Everest — at a cost reported by the FT “set to rise to about $2.5bn by completion even before banks such as Goldman Sachs and JPMorgan take their fees” — means that engagement teams would re-assume their battle stations under extended stresses of time and budget.

Audit teams would be obliged to reach out to their consulting brethren as in the past, for the ancillary expertise necessary to do complex audits. But strained relations and inefficiencies would be predictable, especially if a critical mass of consultants were primarily aiming to negotiate the best achievable departure terms.   

Recruiting would be challenged. On the massive numbers, the firm’s announced hiring spree may either simply reflect that the Big Four continue to be employers of first resort for whole battalions of entry-level cannon fodder, or cover for predicted levels of turn-over, or more ominously, a whistle past a dark and uncertain graveyard.

As for retaining both staff and targeted veterans at the partner and manager level (see Bloomberg’s Amanda Iacone on February 15),  there would be limited attraction in an offer to join or remain with an enterprise where career aspirations go to die.

Suppose the Deal Succeeds

Suppose Di Sibio does achieve his plan to lead EY’s consultants toward a promised land of unconstrained opportunities and munificent rewards. He'd take with him as many A-players as the negotiations would tolerate from among the experts in tax, valuation, cyber security, blockchain, crypto, and all else under the broad heading of Sustainability.

Future events would determine both whether optimistic sources of public or private capital will splash out to enable the much-touted paydays, and whether a newly free-standing consultancy might rocket to success as the next Accenture, or achieve mediocrity in a crowded and competitive field.

That’s a matter of indifference to the capital markets, whose concern must be for the future of AssureCo.

Left behind in that legacy practice would be a rump of tax and other resources, staffed by those either uninterested, unwilling, or uninvited to join the exodus in search of greener pastures. AssureCo as a critical player in Big Audit would find itself challenged to retain, hire, or engage from the outside the resources needed to serve its book of large-company audit clients. 

A key challenge would be the simple one of execution, which has two parts.

The first is in carrying out large-company audits, where audit teams rely of necessity on their colleagues’ ancillary expertise. Consultants at NewCo would not be eager to be re-engaged as audit support, having forsaken EY’s network structure precisely to avoid the constraints of audit. Nor would third-party providers be in ready supply — having no more appetite to limit themselves under the rules of independence and practice limitations that they presently avoid.

And while a part of the pro-split messaging has been that AssureCo would set out to rebuild, replace and grow the practices departed to NewCo, the logic breaks down. That’s because the building of any new non-audit practice would confront the same limitations that are now driving Project Everest. That is, all those who believe that a successful consulting practice is incompatible with auditors would either have exited a combined practice in the first place or would shun a re-building effort in the second.

As for additional factors affecting what must be an atmosphere of uncertainty for EY’s audit partners, there are several.

Those of a certain seniority will be weighing their readiness to hand-hold a portfolio of uneasy clients, against the personal appeal of promptly cashing out whatever incentive payments emerge from the deal and heading for the retirement door. Non-competes, lock-ups and clawback provisions would be only reluctantly enforced — the morale impact of keeping an older cohort “retired in place” would be too gloomy to contemplate.  

The legacy firm will presumably be negotiating to retain the assets and liabilities appropriate to its practice — relevant if relatively inconsequential interests in real estate, methodologies and intellectual property, together with properly identified pension commitments and funding obligations.

But under an estimated reduction in global revenue from $45 to $18 billion, AssureCo would confront its future litigation and law enforcement exposures in a seriously weakened condition. In raw terms, its on-going capital structure and liquidity would have been severely eroded in the negotiations to deconstruct the EY global balance sheet.

Nor is there any reason to think that the departing consultants might agree to a “golden good-bye” adequate to satisfy EY’s current overhang of audit-related litigation, much less to assume any responsibility for the inevitable future outbreaks. For one specific, a matter of current attention and likely contention would be EY’s captive insurance program — a “cookie jar” funded by the willingness of the partners to make sacrifices in their current earnings, and not likely to be surrendered gratuitously by those departing.    

To conclude, the 17^th century French storyteller Jean de LaFontaine put the caution against hubris and over-confidence:

“Ne pas vendre la peau de l’ours avant de l’avoir tué.”

“Don’t sell the bearskin before you’ve killed the bear.”

The Americans’ opposition will not be the end of it. The mischievous energy of disruption has been released, and will not be tamed easily or without consequences.  

 

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Dispatch from the UK: KPMG Settles Carillion –- Whiners Are Not Happy

Guest posted today on Francine McKenna's Substack, The Dig -- a pleasure as always.

 

KPMG has settled the £ 1.3 bn claim brought against it by the liquidators of its client Carillion, the UK outsourcing behemoth whose spectacular collapse in January 2018 triggered an outpouring of the too-familiar criticism, “Where were the auditors?”

Five years on, the entire sorry story is playing yet again to the same tired script.

When the long-anticipated claim was officially commenced, in February 2022, the reaction from KPMG’s leadership was the usual attempted bravado and blame-shifting:  

“We believe this claim is without merit and we will robustly defend the case. Responsibility for the failure of Carillion lies solely with the company’s board and management, who set the strategy and ran the business.”

Now has followed the latest and fully predictable statement of capitulation, from UK CEO John Holt on February 13, 2023 --- which could have been drafted in 2018 and sealed in an envelope marked “Open when needed”: 

“I am pleased that we have been able to resolve this claim. Carillion was an extreme and serious corporate failure, and it is important that we all learn the lessons from its collapse.”     

For want of Mr. Holt’s specification of those “lessons,” let us ask what has been learned –- if anything?

To start, what is not disclosed for the public’s learning is the amount of KPMG’s exit price –- the UK firm using the frequent American tactic of costuming its settlement in a shroud of confidentiality (see the trustees’ claims against KPMG in New Century and against Deloitte in Taylor Bean & Whitaker, and MF Global / PwC).    

Next, depressingly, although there are surely specific lessons available from Carillion about improvements in the technical and complicated reporting, accounting and assurance for large, long-term contracts, none have emerged to inform investors and the capital markets. Not least, that is because the accounting profession has never developed a common forum or other means by which such catastrophes can be put to expert analysis, to be shared for the benefit of all concerned, as is widely done across the business spectrum -- e.g., in aviation safety, structural engineering, medical care, and manufacturing processes.  

One thing we do learn is that the expedient Mr. Holt has reduced by one the number of pending litigation threats against the Big Four that, at their worst, are large enough to be life-threatening. That population now includes, at least, Wirecard in Germany and NMC Health in the UK for EY, and for PwC, Evergrande in China and Americanas in Brazil.

With that small comfort, we also are reminded –- not having needed to learn -– that despite the massive volumes of perfervid critical rhetoric, nothing has been done over the last five years to have any substantive impact on the actual operation of Big Audit, the model by which the Big Four audit all but one of the FTSE 100 and 87% of the FTSE 250.

What has been learned instead is that across the entire body of players, there is a complete lack of will to alter the model:

• The large firms themselves display no discomfort with the current structure of their franchise –- their single gesture having been ready agreement to “operational separation” -- the optically appealing if substantively negligible evolution of expanded disclosure of the organizational and operating distance between their assurance and consulting practices.

• The comprehensive and insightful report and recommendations of Sir Donald Brydon’s “Independent Review into the Quality and Effectiveness of Audit” (December 2019), which recognized the necessity of evolving the assurance model and the qualifications of its professionals, failed to achieve any traction but instead sank without a trace.

• The Financial Reporting Council as the UK’s audit regulator has been shifting its furniture around within what Sir John Kingman described in his December 2018 “Independent Review of the Financial Reporting Council” as its “ramshackle house.” But the prospects that Parliament will actually legislate to re-name and re-configure the FRC as a new Audit, Reporting and Governance Authority –- dead-on-arrival through the years of Boris Johnson and the weeks of Liz Truss –- show no signs of life in the early but distracted and pre-occupied government of Rishi Sunak. Meanwhile as long mooted, Jon Thompson, the FRC’s leader through these fallow years, has chosen to swap one poisoned chalice for another by taking the chair at troubled rail link HS2.

None of this has stopped the whiners, whose petulant voices are heard yet again:

• Annop Rehal of the Haines Watts audit firm (14^th in the UK table -- at £ 105 m in revenue, approximately 2% the size of leaders PwC and Deloitte): the “issue of negligence at the top of the market (is) caused by the lack of ‘real competitors to challenge them’.”

• Gavin Hayes of the Chartered Institute for Internal Auditors: “there is no doubt that there are fundamental issues around a lack of competition in the market.”

For this topic, what has not been learned, or at least is not acknowledged, is the sterility of the discussion on auditor choice and competition, as the advocates for enforced re-structuring of the Big Four’s market dominance have yet to face the reality that the smaller firms lack the capacity, scope of expertise, and risk tolerance to make achievable any such aspirations.

Instead, the complexity of large-company audit and the required range of skills and global presence defy the challenge to carve out for the small firms a portion of such engagements –- either by line of business or by geography, and whether on their own or by forced job-sharing. No assemblage of the firms below the Big Four, singly or in the aggregate, has the necessary capability:

• Performance evaluations by the regulator, and the mix of investigative and enforcement actions involving the smaller UK firms, both caution the prospect of degraded audit quality, should actions be taken to force those firms upon the FTSE-indexed environment.

• A significant reminder regarding audit quality, if needed, is that the case has never been seriously advanced –- much less established –- that “smaller is better.” To the contrary, flares of financial and corporate misfeasance are reported around the globe, all involving the smaller firms: the crypto fiasco of FTX, the Gupta companies in the UK, Lex Greensill’s far-flung structure of companies, and the Adani group in India.

Neither the accounting profession itself nor its hand-wringing critics are heard to advance the difficult if realistic and achievable actions by which to re-engineer a model for large-company assurance that is fit for future purpose. The necessary holistic discussion among all the players awaits.  

 

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Accountants and Their Biases: Human Nature Will Not Be Denied -- Part I

Updating the syllabus and reading list for my graduate-level course this spring in Risk Management and Decision-Making provides a reminder: the members of the accounting profession are just as susceptible as anyone else to the kinds of bias and error that, if avoided, allow for better performance and results. Here the first of a three-part series I am pleased to have written for Caleb Newquist at Gusto:

 

“You can’t expect to improve, if you can’t tell whether you’re good or not.”

Maxim of consultants in decision-making

Trustworthy, high-quality service lies at the heart of the accountants’ claim for public confidence and professional legitimacy. Rigorous standards and high expectations are set for independence of judgment, skepticism, and ethical behavior. 

Yet, to the frustration of the profession, its leaders, and its public critics, undesirable behaviors continue to erupt:

• Large-scale financial failures and scandals that prompt the popular outcry, “Where were the auditors?” –- revealing problems that have been repeated for decades. 
• Corruption of regulatory inspection and oversight through falsification and back-dating of documents and misuse of confidential agency information. 
• Answer-sharing and other cheating on professional examinations.
• Individual violations of trading rules, use of inside information, and breaches of independence rules.  
• Doubts over the profession’s ability to recruit and retain a growing number of properly qualified and skilled personnel, in the context of concerns for academic preparation and workplace environments. 

This despite intense attention and massive investments of time, money, and energy in education, training, messaging from senior leaders, and the development of tools and methodology 

The challenges may seem intractable. But if issues that extend over judgment, skepticism, ethical behavior, and operating priorities are really so hard, are there ways to improve? 

Although the search for simple solutions to complex questions can lead down the road of faulty analysis and wrong answers, a more optimistic perspective is proposed here. Fortunately, we have a half-century of research in the cognitive sciences to open a window into the complexities.

The premise is that accountants share common characteristics with all other fellow humans –- for better or worse. They are not unique or special, differently equipped, or uniquely skilled. They are no less subject to all the influences and pressures that affect and expose the human condition with its frailties and weaknesses.

Which means the news is not all bad. The very opportunities identified in that research have adaptations to the accounting profession’s particular needs. 

Biases, Pressures, and Human Frailty

A rich body of relevant literature sets the stage. A sampling for those interested: 

• The ground-breaking 1974 essay of Daniel Kahneman and Amos Tversky, “Judgment Under Uncertainty: Heuristics and Biases” (Science V. 185)
• Kahneman’s own encyclopedic book, “Thinking, Fast and Slow”(2011)
• Contributors such as Philip Tetlock, “Super-Forecasting: The Art and Science of Prediction” (2015) and Richard Thaler – with Cass Sunstein, “Nudge” (2009 and later editions), and his own “Misbehaving: The Making of Behavioral Economics” (2015)
• A generation of sharp economists, including Steven Levitt and Stephen Dubiner of the University of Chicago, e.g.,”Freakonomics” (2005) and the UK’s Tim Harford, e.g., “The Undercover Economist” (2005) and “How to Make the World Add Up” (2021). 

Greatly simplified, all modern humans carry the legacy of our prehistoric ancestors’ DNA. An early hunter, armed with a spear and hearing the rustling underbrush, faced a critical moment that required an instant reaction: if it were an animal he could kill, the tribe would eat that day, but if a tiger or a wild boar, he was at deadly peril. A stranger emerging from the forest with outstretched hand –- was it in friendship or with a weapon? 

For our ancient predecessors, the fast instincts of “fight or flight” and “friend or foe” were essential to the tribe’s safety and survival, whether against hostile adversaries or vicious predators. Their judgments carried life-or-death consequences for the hunters, although the tribe survived provided they were mostly right, most of the time. 

Those same triggers serve today in many simple cases. When a traffic light changes from green to yellow, no analytic energy goes into a driver’s non-rational “go or no” reaction. Likewise, quick and low-salience consumer choices at a Starbucks counter or a grocery shelf are mostly simple, fast, and non-demanding. 

But these examples show that our DNA has not evolved. The very simplicity of our ancestors’ instinctive reactions means they are maladapted to complex modern challenges. Decisions such as how to allocate an investment portfolio, calculate a reserve provision, where to open a new office, or which candidate to hire are better made with research, deliberation, and consultation.

Like the ancient tribes, today’s society still operates, for better or worse, as programmed for overall survival under normal conditions. This means that decision-making often defaults to oversimplification or resists recognition of the consequential exceptions:

• The very essence of the long-standard auditor’s report, expressed in non-technical terms, conveys a message filled with multiple qualifications — that the client’s information “is generally right, for the most part, over this time period, so far as we can tell within the limits of our work.”
• Likewise, practices and programs for personnel hiring, evaluation, promotion, and management are designed on the assumption that those affected will behave as expected. They act honestly, in good faith, and respond appropriately to guidance and leadership. 

For both of these, the general rules work just fine. Until, under conditions that may seem unusual or unpredictable, they don’t.

The dissonance emerges in both performance and management, because it is the exceptional cases, not the normal and expected ones, that cause the problems (e.g., the white-collar fraudster for whom an audit is an inconvenience to be evaded, the abusive supervisor, the rogue employee).

And that’s when the consequences kick in. Reactions to this bad behavior –- from the profession, its clients, the general public –- can be put in the terms used to discipline unruly children, “when you do right, nobody remembers; when you do wrong, nobody forgets.”

The Ubiquity of Human Bias

The literature has cataloged an entire vocabulary of human bias and error that pervades the accountants’ environment as much as any other area of business or professional services. The irresistible human impulse to simplify complex problems leads to narrowed questions that, by default, are often answered with little time and energy –- and too frequently answered incorrectly. 

Examples from a long list will illustrate.

                                                     In General            In the Profession

The Induction Fallacy (Mistakenly believing that past experience is a complete guide to the future)	It’s only the flu	The CFO has never misled me before
The Planning Fallacy (Over-confidently disregarding the likelihood that unforeseen changes will affect a project’s execution)	The opera house will be finished on time and on budget	Our report is on schedule –- we don’t expect any disruptions
The Anchoring Effect (Over-weighting quantitative information that is visible although not complete or relevant)	“Buy three tires, get fourth free” -  bargain	Receivables  look light–bump of 5% should do it
The Optimism Bias (Ignores evidence inconsistent with desired outcome or narrative)	Our troops will occupy Kiev within two weeks	Client growth 15% last year, so 20% this year is a lock
The Inertia Effect (Continuing past practice, whether or not in a changed environment)       The Bias of Representativeness (Extending an assumption based on limited information)	NASA shuttles launched for years –Challenger good to go     Dressed like that, he surely doesn’t belong here	Scope was fine last year -- SALY     We don’t send recruiters to schools with that ranking

These examples — illustrative and by no means comprehensive -– are common throughout the profession, as they are in society as a whole. And they share a common theme. They all arise out of the natural default to quick, simple, and intuitive reactions inherited from our ancestors that are ill-suited for modern life’s complexities.  

The guidance of the research is best summarized by Richard Thaler (Misbehaving, pp. 355-56): 

"It is time for everyone –- from economists to bureaucrats to teachers to corporate leaders –- to recognize that they live in a world of humans and to adopt the same data-driven approach to their jobs and lives that good scientists use.

"Good leaders must create environments in which employees feel that making evidence-based decisions will always be rewarded, no matter what outcome occurs. The ideal organization encourages everyone to observe, collect data, and speak up."

A word of caution: perfection is not within the grasp of fallible humans with our in-built limitations. “Zero defects” is not achievable, nor does the awareness of our sources of bias assure consistent use of the tools available. But the deliberate aspiration to improve, being the best we can do, has promise.  

Installments to follow will suggest some means to take these thoughts forward to practical application.

 

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