Re:Balance -- Jim Peterson

Can the Accounting Regulators Picture a Future Without the Big Four?

Saying the Unthinkable

Published in the IHT on November 10, 2007

There's a deep-seated and superstitious refusal to name what we fear. Believing "Macbeth" to be unlucky, Shakespearean actors refer only to "the Scottish play." Harry Potter's fellow students of witchcraft and wizardry refer to the dread Lord Voldemort only by the euphemistic "He Who Must Not Be Named."

The trouble is, anxious evasion of a problem can help to bring it on.

Or so it is after the gloomy reaction in Britain to the report last month from the Financial Reporting Council on possible relief for the accounting profession (here).  Attention is now over to the United States, where wise heads are gathering, under the auspices of the U.S. Chamber of Commerce and the Treasury secretary, Henry Paulson Jr.

Despite the threat to the survival of the Big Four accounting firms, none of the players - not the Big Four leaders, regulators or politicians, or the community of financial information users - will say it straight out: The large auditors' business model is broken, and their risks are unsustainable. The next large-firm failure will take down the other Big Three as well, just as fast as Arthur Andersen crashed in 2002, leaving large companies unable to obtain the current form of audit report from any source.

And why is nobody willing to ask what life will be like after the Big Four?

For that, I had a long talk recently with a senior accountancy regulator, who acts in a large country vital to the global capital markets and the future of the auditors. We found ourselves agreeing on the unappreciated necessity to confront a Big Four collapse and on the essential impotence of regulators or politicians.

We also had complementary approaches to the possible form and look of post-collapse assurance: In his world, beefed-up internal audit departments would report, with as much independence as they can muster. Audit committees would review and endorse the internal audit reports. And outside auditors would assess and report on the sufficiency of the internal auditor's resources, competence and scope of work.

Importantly, this latter report - well within the audit profession's capabilities, thanks to the experience gained under the requirements of Sarbanes-Oxley - would not require the scope of resources or the cost models of the current large firms.

In my world of the future, company reporting would be done by finance directors, on the basis of work done by outside firms, engaged from among the local and industry-based practices that would emerge from the wreckage of the Big Four. These firms would target their audit procedures and report on specific company areas ripe for attention - like a complex treasury function, a portfolio of risky assets, a troubled company operation or a first-time product or process.

From these two models, merged together, would emerge new forms of reporting and assurance, testable in the capital marketplace for value and utility to users.

And how would this all work, in a post-Big Four world?

First, internal audit departments would readily attract qualified personnel, out of the rosters of the late large firms, at compensation packages attractive to experienced accountants who would prefer the stability of corporate life over the uncertain risk and reward of the current fragile partnerships.

Second, the niche practices that held together after the large practices split up would also thrive in a new competitive environment. Their offerings would include the accounting expertise on which large enterprises will continue to depend, the new reports on internal audit departments, and the specific industry and geography-based assurance that finance directors will outsource and sell onward to the financial community.

Restructuring the current staffing models of the large firms, after the disintegration of their networks, would take one single recruiting cycle. The newly emergent practices would then operate with leaner resources, reduced costs and a profitable revenue model no longer hostage to failed attempts at pricing for the risk of unbearable litigation.

Third, and the driver for the first two, none of this reporting would ever claim to be in compliance with today's liability-ridden securities regimes, whose reporting requirements would have fallen to ineffectual disarray along with the firms themselves.

Instead, reports would be issued under strict limitations of liability to companies and their book of shareholders - not to the investor community and exploitation by the plaintiffs' lawyers. Reporting auditors would neither have nor claim independence in its now outmoded form. A truly competitive environment for assurance solutions, valued on a market-led basis, would replace the model that today is past its time.

Whatever the fear of speaking the unthinkable about the next era of large-company assurance, it is now on the table. There is a broad-based symposium, waiting to be convened by a top global regulator, under the title, "The Future of Auditing After the Big Four." If the boy wizard Harry Potter could name, face and overcome his nemesis, a group of adults should be able to do no less.

Big Four or Mid-Size -- Can the Regulators Save the Accounting Firms?

Can Midsize Auditors be Turned into Big Ones?

Published in the International Herald Tribune on October 20, 2007

Cinderella has been invited to the ball. Or so you might be tempted to think, if you were the leader of a middle-sized accounting firm.

Tuesday saw the release of "Choice in the U.K. Audit Market," a report from the profession's regulator in Britain, the Financial Reporting Council. To give large companies a greater choice of auditors, the FRC - playing the role of Fairy Godmother - proposes to allow any firm smaller than the dominant Big Four accounting networks to be hired to audit the largest companies, releasing them in the process from their perceived state of drudgery and inferiority.

The FRC would make the smaller firms more attractive by opening their ownership to the outside capital needed to expand their capacity, and by jaw-boning both large companies and their bankers into offering audit work to these newly empowered firms.

Trouble is, the historic trend goes straight the other way. Audits for large companies are dominated by the Big Four, including all of the FTSE 100 in Britain. So although the FRC explicitly plumps for "market-led" solutions to this state of concentration, the market's own reaction has been a kind of cringing distaste - sort of like when your best friend asks you to take his little sister to the dance.

Also, there are signs that the mid-sized firms themselves may not be quite up for the big partying. Instead of standing alone and growing beyond the current limitations on their geographic scope and economic strength, as the FRC's program would encourage, the smaller firms are moving in the opposite direction.

In France recently, the Constantin network - 30 local firms spread over 60 offices - forswore its middle-market niche to unite its 500 employees with the 5,000 at Deloitte. In Britain, the RSM network has seen its affiliate Robson Rhodes run off into the arms of Grant Thornton, the No. 4 firm.

The FRC's second concern - to reduce the risk of another large-firm collapse, or to mitigate the effect if that should happen - is even chancier than the smaller-firm issues.

Despite the good news that the judge handling the Parmalat litigation in the United States has thrown out the claims of non-U.S. plaintiffs, Grant Thornton, whose Italian affiliate had been Parmalat's auditor, still confronts potentially deadly litigation from the collapse of Refco, the high-flying commodities broker in Chicago that Grants picked up as a client after the demise of Arthur Andersen in 2002.

I spoke this week with Paul Boyle, chief executive of the FRC, from his office in London. Boyle's modest aspiration is that the report's recommendations might make the world of financial assurance "a little less risky, and a little safer."

He has in mind the real probability of the disintegration of another large network, like Laventhol in 1989 and Andersen in 2002, under litigation liabilities that their capital cannot cover. That brings to the fore the prospect that a loss of another of the Big Four would lead not to a sustainable Big Three, but "four-to-zero" - a complete
collapse of the franchise of large-company audit assurance.

To prevent or mitigate that result, the regulators' available tools are "very limited," Boyle acknowledged. And as the recent tumult in the credit markets has proven, when a meltdown is underway, neither regulators nor the elusive "market" are always capable of bring things back under control.

Instead, if another Big Four collapse is imminent, Cinderella's coach becomes a pumpkin again - there being no agency or authority with the vision, the interest or the capability to stop it.

So take the FRC report as serious bedtime reading. And sweet dreams.

The Big Four's Litigation Cost: A Matter of Survival

What litigation cost would kill a Big Four accounting firm? Since this column first appeared, the responses have been remarkably quiet on two aspects: neither any disagreement with the shockingly small numbers, nor any credible claim that a political or regulatory solution is achievable. 

The Impact of Unheard Bullets 

Originally published in the International Herald Tribune on December 16, 2006

Business vocabulary borrows freely from the military: control battles, hostile raids, road warriors, chain of command.

Today's example is this axiom of warfare: "You never hear the bullet that kills you."

Last week I was with a retired partner of a Big Four accounting firm who has plenty of reason to be on full alert for silent killers: His pension is contingent on the doubtful durability of the large firms' cartel to audit the world's large companies.

The discussion of possible changes in the regulatory regimes for corporate financial reporting is rapidly expanding. It includes a full menu of ideas proposed in Brussels, London and Washington. But the reactions to any proposal for serious adjustment to the American auditor liability regime range all the way from lukewarm to downright hostile.

Those antagonistic views are based on the disbelief that there will be another collapse. That, in turn, is based on the persistently erroneous view that the disintegration of Arthur Andersen in 2002 was caused by its Enron-related indictment.

Hear this now: The unheard deadly bullet was Andersen's litigation exposure. And that has grave implications for the remaining Big Four.

How likely is it that another big- firm implosion could happen? As with Andersen, it would involve an emotion-driven breakdown in confidence — the simultaneous outflow of clients, collapse of an international network and flight of partners.

Although client flight will be severely constrained the next time around, with the lack of auditor choice available when the current Big Four drops to three, the other two factors can be quantified. And it's not a matter of exposure to prosecution.

While we await a promised talking paper from Charlie McCreevy, the European Union commissioner for internal markets and services (now available -- see here) , a supporting report prepared for him on Oct. 4 by London Economics, a consulting firm (here) , has calculated the size of the litigation hit that would disintegrate a large European linchpin accounting practice.

The report's assumptions, extended to the more threatened U.S. litigation environment, are truly scary in that they demonstrate the fragility of the large accounting firms' franchise.

To set the stage, recall that there are three reasons why the large accounting networks are forced to finance their large litigation settlements out of their partners' future profits:

First, by local codes they are barred from access to public shareholders or other equity investment.
Second, the partners' personally invested capital is on demand for working purposes.
Third, the insurance market no longer provides real risk transfer, but instead is at most a source of time- shifting finance.

The key to survival, then, lies in the willingness of the partners to stay committed and at their desks — something that the Andersen partners did not possess, as proved by the two- week period in 2002 during which they bailed out en masse and thus smashed the firm beyond recovery.

The study done for McCreevy calculates that the partners of a European firm would bolt, in numbers large enough to be destabilizing, rather than be forced to finance a litigation payment that extracted a profit reduction of 15 percent to 20 percent spread over three to four years.

Applying those assumptions to the Big Four's latest reported U.S. revenues of $4.7 billion to $8.7 billion (write me if you want to hear the numbers crunch), the dispiriting result is that the U.S. firms will confront partner flight and possible failure at liability levels as small as $450 million and up to $1.8 billion.

Those amounts are modest to the point of insignificance against the size of this decade's financial debacles — examples ranging from the $20 billion hole in the balance sheet of Parmalat to Enron's own $67 billion bankruptcy. Little wonder there is no public support for liability caps in the auditors' favor at levels low enough to protect them from collapse.

These assumptions also make plain that the Enron-inflicted blow on Andersen was mortal. The firm's 2001 worldwide revenue was $9.3 billion. It confronted plaintiffs' lawyers claiming that the case would be the first against accountants to reach $1 billion. The crippled firm was already dealing with claims involving Baptist Hospital, Waste Management and Sunbeam, and it was about to receive the incoming bombardment of WorldCom and Qwest, among others.

So to blame Andersen's death on the Enron indictment misses the point. The firm was like a terminal patient on late-stage life support who happened to succumb to a fast-moving staph infection: Its demise was imminent, and inevitable.

The report this month (here) to the U.S. Treasury secretary, Henry Paulson Jr., on a broad-ranging set of proposals for regulatory change,  notes that the Big Four's litigation inventory in the United States includes 22 actions, each with damage claims exceeding $1 billion — and that's without contemplating their lesser but not trivial cases, or the new matters that will inevitably arise in the months to come.

All of these will eventually be settled; witness the announcement last week that Deloitte will settle the shareholder piece of its Adelphia litigation for $210 million. Managements are too risk-averse to risk a life-threatening jury result at trial.

The Big Four might each survive one such impact from this barrage of lawsuits — although even that is a big if. But a second direct hit on any of them would be the last explosion they ever heard.