Re:Balance -- Jim Peterson

Disintegration of the Big Four Audit Firms? As They Tell the House of Lords, "We Don't See That on the Horizon"

The epitaph for the private delivery of audit services to the world’s large global companies was written in London on November 23.

During its generally amiable ninety-minute stumbling around the topic of auditor concentration – available here and observed on here and here -- the House of Lords Economic Affairs Committee queried the invited heads of the Big Four, “You do share the general unease about the fact that it could be Four coming down to Three?”

For the quartet’s response, the senior partner of Deloitte’s UK firm, John Connolly, contributed this entry to the lexicon of the self-deluded: “I don’t see that on the horizon at all.”

Which will go down next to the grim valedictory of Citigroup’s Chuck Prince in July 2007, that “as long as the music is playing . . .we’re still dancing,” only months before his forced departure, or – closer to home – PCAOB chairman William McDonough’s concession in September 2005 that among the regulators, “None of us has a clue what to do if one of the Big Four failed.”

Although memorable language would not be expected from a “numbers guy,” Mr. Connolly’s invocation of an empty horizon has real resonance.

Military comparisons are inevitable – and instructive. General Custer did not foresee danger from the invisible Indians. The American forces at Pearl Harbor were heedless of the approaching Japanese. And to Hitler, the beaches of Normandy were both well-defended and bare of Allied threat.

While in this decade’s uniquely impactful if unforeseen event, nineteen Saudi thugs with box cutters in their backpacks begat a world-wide season of terror, destruction and disruption, the effects of which have altered history.

As with these examples, and the grievous lessons that emerge only in the hindsight of the short-sighted, Mr. Connolly’s handicap is the limit on his vision – because a clear view of a blank horizon is of little value if the surveyed circumference extends no farther than arm’s-length.

I am indebted to my friend Shyam Sunder at the Yale School of Management for the Sanskrit folk tale of koopa mandooka – the “frog in the well”, which lives in blinkered comfort so long as confined within the boundaries of his closed little world.

But should he venture forth, the perils of the world outside are unknown. It may indeed be a paradise, full of succulent insects and comfortable lily pads and luscious companions with which the frog can disport and sire entire populations of little tadpoles.

Or, it may be a hell of deadly predators – voracious snakes and hawks and sharp-toothed fish. Or a searing desert beyond the fringes of the oasis, where a clueless frog will be pan-seared in minutes.

Unless informed and prepared, the frog in the well has no way to differentiate a prosperous future from one of mortal danger.

And the consequences of his ignorance are just as fatal as those of being wrong.

Here’s what the Big Four leaders might have said, in answer to the Lords’ call:

“We not only share your unease. We are terrified for the survival of our firms – not so much for our generation, who if fortunate may hope to ease soon into retirement, but for the future of a profession that depends for its sustainability on the talent and commitment of our younger personnel.

“Our ability to provide valuable assurance remains important to the capital markets. But it must evolve beyond the binary choice, whether or not to pronounce “true and fair” -- a choice exposed in the banking crisis by our delivery of unqualified audit reports on soon-to-fail institutions as not only unresponsive but affirmatively dangerous.

“Yet we are shackled to obsolete reporting by regulatory requirements confining us to an unhelpful commodity product. What is needed is no less than a fundamental re-structuring, under which:

• “Supplanting the current report form which no longer serves a useful purpose, we could tailor our reports to the real needs of particular users.

• “Our ability to deploy a full range of services would include access to the expertise of non-audit personnel to achieve more sophisticated performance and improved quality.

• “The interests of investors would be reasonably supported by government oversight, enforcement and protection such that our reporting would not create liability exposure of a magnitude that would destroy us.”

They might have said that. But they didn’t. For want of a vision extending to that far but visible horizon, a golden opportunity was allowed to pass. 

 

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The House of Lords Looks at the Role of Auditors: And Then Everyone Went for Tea

 Here’s a good way to increase the chances for satisfaction: start with very low expectations.

That was my approach, anyway, in dialing up the broadcast by Parliament TV of the House of Lords Economic Affairs Committee session of November 23, billed as a look at concentration in the audit market and the role of the auditors in the financial crisis -- here.

As a soporific, it was a decent substitute for televised football as a way to sleep off the after-effects of the Thanksgiving feast – watching the heads of the Big Four practices in the UK bat away slow-pitch questions that ranged from the naïve and misinformed to the incomprehensible.

Plainly, the intractable challenges to the viability of the large-company audit model are at no risk of being solved at the hands of the British legislators, whose depth of inquiry ran the gamut of complexity from A to B.

Examples:

• “Are you happy” with the degree of market concentration? Well, what’s not to like -- although it can hardly be admitted, when the Big Four control the entire large-company audit market with no prospect of competition.

• What about a threat to withdraw from the audit market? Oh, not us, your lordships – audit is at the very core of what we do!

• If that’s so, “are you uneasy” that the large firms would go from four to three?

• With a straight face, “we don’t see that on the horizon.” Of course not – while at the same time conceding that although the events of the credit crisis were “unprecedented,” there are “lessons to be learnt” for everyone.

Sometimes the unthinkable does happen – as the events of the last three years have made clear. So where was their lordships’ follow-up question: 

What would you do – what would any of us do – if despite your intentions, one of the firms incurred what was described with wonderful British euphemism as an “Andersen moment”?

And for this, there was no suggestion of an answer from either side of the tables. 

In the middle third of the proceedings, their nobilities were able to become better informed, if not wiser, as their invited guests gave a concise run-down of the irrelevance to audit concentration of a list of unachievable ideas -- namely:

• Break-up of the Big Four would add nothing to global-scale competition, since – against the breadth required because 80% of the revenue of FTSE 100 companies is generated outside the UK -- the resulting fragments would lack scale, coverage and investment capability.

• The current restriction on scope of services to audit clients – where last year no FTSE 100 company paid consulting fees to its auditor – is claimed to be working well: an assertion which, considering the unsolved nature of the survivability threat, means that if the current environment represents success, what would failure look like?

• The arguments for joint audits or mandatory rotation founder on the examples of degraded quality – the likes of Parmalat in Italy and BCCI in the UK itself.

• And the howler of the day: if audit is “implicitly a form of insurance,” why does that industry not ride to the rescue? – a proposition so discredited that even the committee chair hastened onward.

The hearing wound down to a clearly rehearsed and well-choreographed five pm break for tea, but not without an “Alice in Wonderland” go-round on the question of the auditors’ issuance of unqualified opinions in the months before the failures of such British institutions as Royal Bank of Scotland, HBOS and Northern Rock.

At the assertion that the auditors actually “performed well” in light of the complex events of 2007 and 2008, adjectives such as “astonishing” and “misleading” were tossed around both in the hearing and amongst subsequent commentators – here.

But why should anyone be surprised?

The pointed observation by one of the Big Four that the auditor does not assess the risk of a business, but renders a report in identical language, whether the leverage of the enterprise is 100 times or none at all – starkly contrasted with a plea from the questioners that an assessment of the “dangers" in a business is precisely, if simplistically, the assurance sought by a wishful user community.

In that context, the fact that the technical reporting requirements were satisfied, to avoid a going-concern qualification – if only through closed-door communications with the Bank of England and the Financial Services Authority – finally exposes the raw insufficiency of the current audit model.

As was equally the case in the 1980’s when the American auditors trailed the emerging catastrophe among the savings-and-loans, the profession lacks satisfactory tools when the regulatory regimes put them to the choice -- whether to qualify their opinions and generate a self-fulfilling prophecy of disaster, or to rationalize a demonstration of the emptiness of the report that constitutes their core product.     

If that much could be taken as established once for all, before everyone went off for tea, then unlike the case with most such posturing displays, the day was not a complete waste.

 

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The European Commission's Green Paper on Audit: After the Posturing, an EC Agenda for Real Progress

Say this for EC Internal Markets and Services Commissioner Michel Barnier’s call for public comments on his October 13 green paper, “Audit Policy: Lessons from the Crisis”:

No sooner had I sent in my own ill-tempered two euros worth – here – than my readership statistics showed a serious spike from addresses across the European Union. There’s real interest out there!

Having taken M Barnier to task, I was rightly challenged by readers to stop complaining and be constructive. So with a response deadline of December 8, this is to invite all those concurring that more is required from Brussels than a feckless and ill-informed exercise in redundancy, to register their views at the EU site – here.

The message is this:

All that needs be known is already at hand, to build the agenda for a really effective discussion on the re-engineering of a sustainable audit function to serve the world’s global-scale companies.

It would have these three components:

• Certain basic truths would be taken as established.

• Any further reference to the over-debated but impractical or unachievable “non-starters” would be barred.

• Focus would be on the handful of truly difficult, challenging questions – on which views would differ profoundly, but which are inescapably important to any progress.

In the first category, there may not be consensus on all details, but these propositions are basically beyond debate:

• Other than for purposes of statutory compliance, the standard one-page audit report no longer serves a function that justifies its cost to issuers or the exposure it imposes on auditors. Evolution to new forms of assurance is essential.

• The concentration of large-company audits among the Big Four is down to a critical minimum. A three-firm model is unworkable; failure of any one will disintegrate the entire structure.

• The organizational and capital structure of the Big Four leaves each one exposed to an unsustainable shock, from regulatory or law enforcement proceedings, or a civil litigation outcome in the $ 1 to $2 billion range.

• Regulators and politicians lack the vision, authority or means – separately or collectively – to rescue and sustain a large accounting firm once a shock tips it into a downward spiral.

In the second category, the catalog of “non-starters” includes:

• Liability “caps”, whether monetary limits or allocated percentages of responsibility.

• “Break-up” of the Big Four firms – an act of aggression having neither a rationale nor a basis in law. 

• The emergence of new global-scale entrants to the Big Four’s audit market, whether by merger, subsidy or organic growth. 

• The injection of outside investment into the Big Four’s capital structure, or alteration of existing ownership restraints.

• Mandatory auditor rotation or replacement.

• Contingency plans to replace the management of a firm under existential threat.

• Re-introduction of genuine forms of private insurance, by way of “catastrophe bonds” or otherwise.

Finally, to table a selection of the hard but unavoidable questions:

• What are the forms of assurance that issuers and users would actually value and pay for, and what structural changes are required – competitive, organizational, legislative and regulatory – to enable the evolution of a profession capable of meeting those needs?

• What form of regulatory oversight, inspection, enforcement and discipline would achieve a sustainable balance between investor support and protection and an audit function that is both disciplined and robust? In particular, what is the necessary form and amount of financial involvement of government – whether an investor protection fund, insurance of last resort or otherwise?

• Under a newly-structured audit delivery model, and with a comprehensively refreshed legislative mandate, what are the proper limits and guidelines on the scope of services deliverable to audit clients, and what re-visiting of concepts of auditor independence and conduct are indicated?

The envisioning of a symposium devoted to such an agenda – much less its convening – has yet to occur. Until it does, and the process moves on to real substance, the stability of the current audit model and the four firms providing most of its delivery are both at risk.

 

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The Big Four Accounting Firms Are Down to Critical Mass: Says the Financial Times - So It Must Be Official

In the country where the independent audit was invented, back in the Victorian era, the Lex column in the Financial Times has finally bought into one of the messages I have been flogging for years – here -- about the fragility of the global franchise of private-provided assurance -- here:

    The Big Four are down to critical mass.

It’s a subtle but real shift in language, away from the usual mushy euphemisms of the regulators, that another large firm failure “could disrupt the market” – as put in the vacuous prose of the EC’s recent Green Paper (see here).

As finally put forthrightly by the peach-colored London paper:

“(I)t is vital to work out how to deal with a repeat of the Arthur Andersen/Enron affair, because four is the minimum number of global accounting groups needed for a healthy industry. Many companies employ one firm for internal audits, another for the external audit and a third to offer consulting advice. The fourth player picks up the slack when a change is needed. Neither regulators nor customers would want to see the Big Four turn into the Big Three.” (emphasis added)

The discussion can now move on, if only by further small and agonizing steps. The next one, which the FT is on the very verge of taking, is the explicit realization that an unsustainable three-firm model will go into immediate collapse – not least because the survivors after the next disintegration, which will occur in another Enron-like spasm of recrimination and finger-pointing, will have neither the appetite nor the resources to pick up the wreckage.

The FT is close, but not there yet – because still fixated on either of two non-achievable approaches: 

“(I)f that happened, regulators would be left with two unappealing options. First is a forced split-up of the remaining accounting groups – a plan that would meet vehement opposition. Second, an ambitious smaller outfit could take over the ailing giant, roughly as Nomura took on Lehman Brothers’ European operations. But any non-Big Four auditor would face a huge challenge doing this, since these firms rarely work with big or even midsized companies; they audit only 5 per cent of the UK’s FTSE350.”

Been over this ground often before – here. Opposition aside, not only is there no legal authority anywhere for cleaving the Big Four into smaller bits. As a practical matter such a split would have to be done in all the major global financial jurisdictions – none of which has a regulator or legislature capable of conceiving such an idea alone, much less in concert. In any event, the result would only be a group of smaller and weaker firms, with unevenly distributed personnel, industry expertise and capacity for execution.

And if the FT’s writers would please do their sums, they could face the reality that – good as they may be, and that is not assured -- the smaller firms lack the scale, coverage and execution ability ever to play at the level of the world’s global-scale companies.

There are critics of the large accounting firms whose long-winded rants amount to an unqualified charge of auditor venality and corrupt client deference to the exclusion of public interest.

That is not a view I share, and not only because the perfervid rhetoric fails to offer constructive solutions. It’s because the inter-locking antagonisms that capture and paralyze the current audit structure also imprison a profession caught in an obsolete model of excessive and unmatchable expectations.   

The Lex conclusion isn’t wrong:

“There may be better ways to keep the auditing business competitive. Regulators and accountants should look for them now, rather than wait for the next scandal to force their hand.”

To be successful, that search will require escape from the “intellectual capture” that now prevents the entire interested community from conceiving solutions outside their limited vision.

And to be timely, it needs to start now.

 

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