Considering the vacuity of the debate on the survivability of the Big Four audit firms and the delivery of audits to large public companies, especially at official levels – see here – there should be full exploration of all ideas that at least pass a laugh test.
So I was tantalized by Tom Selling’s suggestion last month (The Accounting Onion) to reincarnate a “Big Eight”, if “the government could offer to share the litigation exposure from each of the Big Four’s prior audit engagements in exchange for [their] splitting up into two completely separate firms.”
Well, maybe. But anyone thinking that large-company audits would be helped by hacking up the large firms should consider this tool: the razor named for 14th century English friar and logician, William of Occam, whose rule of succinctness states that all things being equal, the simplest solution is the best.
Beyond the purely political issue that auditor liability reform is an officially toxic topic in Washington, and the absence of any legal foundation for such slicing and dicing, there are some practical issues:
First, unless the Big Four bifurcate their industry teams, no new competition would emerge. That is, if a current Big Four health care or insurance practice spun off as a whole into one new firm, while its technology or energy practice stayed intact but went to another, the range of auditor choice within an industry would not be expanded.
And the glacial and ineffective pace of change within the profession itself makes it unlikely that senior experienced audit personnel would have the incentive or take the initiative to re-tool their expertise from one industry over to another.
On the other hand, however the Big Four firms might be broken up, it would not reduce the complexity or resources needed to audit a large global company. For example, each half of a firm’s split-up banking industry practice would still require a full-bore set of technical and regulatory expertise. With the loss of economies of scale, duplicating such competence would reduce efficiency and increase rather than reduce the cost of large-client engagements.
Relatedly, on the issue of performance quality, Selling suggests that the Big Four may have grown “too decentralized to control.” But to serve global companies, Big Four practices riven in two would still need a serious presence in all the countries where their clients require service. That challenge of scope, scale and resources is not solved today by the Big Four’s smaller brethren – and would present an immediate quality challenge to any Big Four offspring.
Which asks the question whether division would be desirable beyond the US, in countries deemed to be low risk. Are there any candidates? Significant litigation now originates in engagements or companies as far-flung as Italy, the Netherlands, Russia and South Korea. So countries attractive for firm mitosis may be few indeed. And with one or two of the Big Four typically dominant in the larger non-Anglo countries, division of the firms only in the US might well have perverse effects on concentration elsewhere.
As for the economics of a bail-out, leave aside the political improbability that government would assume a litigation exposure currently estimated to exceed $100 billion. True, the cost of a rescue would be chump change compared with the taxpayer burden looming over the impending rescues of Fannie Mae and Freddie Mac – but public passions are far less aroused for auditor salvation than for the country’s dominant home mortgage institutions.
The idea is a non-starter for other reasons, starting with the impracticality of doing a “one-off.” That’s because protecting the Big Four from today’s catastrophic litigation threats does nothing for the future. Any new mini-firm would, post-split, still be exposed to the next generation of cases that – based on four decades of experience – will inevitably arise.
And it would not bode well that smaller, capital-challenged new firms would have only half the financial resources they do now, when they are already facing litigation-driven extinction.
There is one positive glimmer in the heart of Selling’s idea – a stand-alone government assumption of the large firms’ catastrophic exposures.
Today the Big Four are forced to settle their biggest cases. They lack either insurance or partners’ capital robust enough to take the non-trivial risk of going to trial and incurring a punishing adverse outcome.
It cannot be imagined that politicians would create a $100 billion honey pot for the investor plaintiffs and their lawyers to dive into. But there could indeed be created a federally underwritten catastrophic re-insurance mechanism or “litigation trust” – which as a form of contingency capital would enable the firms to litigate their cases without fear of a death-blow verdict.
If such a lifeline were available, it would obviate the viability threat. So simplified, the very reasons for the otherwise impractical Big Four split-up go away. The firms in their current form could then address their twin goals of quality and relevance, without the distractions of imminent overhanging bankruptcy proceedings.
Using Occam’s Razor to pare away the parts that fail to benefit audit delivery effectiveness, the Selling proposal suggests a financial buffer worthy of consideration. That idea would logically be housed in the proposal I outlined on June 10 – here -- for a government-sponsored structure of charters for firms doing audits of publicly-traded companies.
So let the discussion continue.
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