The Financial Fragility of the Big Four Accounting Firms – Updating the “Tipping Point”

            “Predictions are difficult. Especially about the future.”

-- Variously attributed to an old Danish proverb, physicist Niels Bohr, and Yogi Berra

It’s a new year. The holidays are over. Time to sober up, get back to work, and re-fresh this sobering question:  

How big is the “worst-case” litigation hit that would disintegrate one of the surviving Big Four?

Since the post-Enron collapse of Arthur Andersen, it has been too easy to ignore this gloomy topic in a combination of indifference, unease and denial. But the answer matters. Financial information users should care, because the loss of the next firm would bring on the collapse of the entire structure of Big Audit – the system of privately-provided assurance on the financial statements of the world’s large companies.

I did this first in December 2006, with periodic updates, even as the Big Four have shown continued growth – total global revenues for Deloitte, EY, KPMG and PwC for fiscal 2014 are up above $ 120 billion.

Back in September 2006, a report by the consulting firm London Economics to the EU markets commissioner modeled the collapse of a Big Four partnership in the UK.

As had actually happened at Andersen in 2002, the model quantified the level of personal sacrifice, beyond which the owner-partners would lose confidence, withdraw their loyalty and their capital, and vote with their feet.

The London report observed that the firms’ viability would be hostage to the combined effects of a highly-charged crisis environment, reputational pressure and the hostile publicity of a massive adverse litigation result. Using a variety of scenarios and assumptions, it concluded that critical numbers of partners would defect, so as to put a firm into a death spiral, if they faced a profit reduction of from fifteen to twenty percent that extended over three or four years.

Bearing on the model, but poorly appreciated if at all, is that the Big Four networks operate on razor-thin levels of financing, for three reasons:

• Their financial needs – employee salaries, space costs and technology and methodology investments – are covered out of client-derived revenues.
• Income taxes in the largest countries are cash-based for partners -- a powerful incentive for the firns to distribute out their current income.
• And with no alternative need for excess capital or outside investment, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding tanks.

By extending the London Economics assumptions to the global level and coming down to date, break-up figures for the Big Four can be calculated -- from an optimistic maximum of about seven billion dollars down to about three billion.

But this is only the first step. Those are world-wide numbers, which assume that a Big Four network under deadly threat could maintain its global integrity and the on-going support of its firms and partners around the world.

The contrary was unfortunately illustrated by the flight of Andersen’s non-US firms in 2002. Cohesion of the international networks under the strain of death-threat litigation, or the extended availability of collegial cross-border financial support, cannot be assumed.

So calculations must be made on the Americas alone -- the US being still the world’s most hazardous litigation venue. Left to their own resources, as was Andersen’s US firm, the tipping points for the US practices shrink to a range from $ 3.6 billion down to a truly frightening $ 900 million.

Ominous and shockingly small as are these litigation-driven figures, they have never been disputed. A public discussion would be illuminating, but financial fragility is a “third rail” topic for the profession’s leadership. No alternative models or other estimates have ever been offered. Nor is there anywhere in sight any credible claim that a political or regulatory solution is achievable.

Is there a persuasive case that it won’t happen – especially in the face of the empirical evidence of Andersen’s collapse, that it truly can? The answer, with regret, is negative.

In the aftermath of the financial crisis of 2007-2008, the large accounting firms disposed of huge litigations for remarkably modest sums – examples include KPMG resolving Countrywide and New Century, Deloitte settling Washington Mutual, and EY settling the private investor portion of its exposure in Lehman Brothers.

But multi-billion dollar figures have become all too common and familiar, e.g., to settle claims relating to the financial crisis, the sales of mortgage securities, and LIBOR and Forex rate-fixing. Bank settlements reported for 2014 alone have totaled over $ 56 billion -- led by Bank of America’s agreement in August to a sub-prime-mortgage settlement of $ 16.9 billion, and the $ 8.9 billion fine finally agreed by BNP Paribas the following month, after the tone-deaf intervention tactics of the French government officials.

Outside the financial sector, perhaps heading the list of complex mega-settlements is the total for BP arising out of the Deepwater Horizon oil well catastrophe -- $ 4.5 billion in fines and penalties, and $ 13 billion (and growing) for claimed loss by businesses, individuals and local governments.

Those settlements and government fines could only be funded, however, out of the investor-supported balance sheets of the publicly-held banks and other corporate defendants. By contrast, third-party equity is simply not available to the private accounting firms owned by their individual partners.

Given the continued myth that the Big Four are protected by insurance, it must also be noted that these numbers are net of whatever cover may in fact be available. Which is neither good news nor especially relevant.

That is because of the effective absence of commercial insurance coverage of the large firms at the currently expanded catastrophic levels. The fickle cyclicality of the insurance market means that even today’s shrunken, thin and ragged insurance capacity would ill protect against the chilly horrors of the inevitably recurring new litigation nightmares.

To recap, these numbers matter because loss of another Big Four firm would throw the entire system into chaos – for lack of auditor choice and readiness among the survivors to stay in an unbearably risky business.

Accounting and assurance have been essential to commerce going back to the earliest records of societies engaged in trade. But the partners of the large firms are not indentured, nor on-call hostages to the unexamined assumptions of the world’s politicians and regulators.

Yet the reactions of regulators, politicians and the general public to any serious adjustment to the potentially fatal Big Audit liability regime range from lukewarm to downright hostile.

It cannot be assumed – just because the surviving Big Four were able to absorb the clients fleeing Andersen in 2002 – that a Four-to-Three scenario is viable today.

To the contrary, the Big Four are already down to a critical minimum. The uneven concentrations of personnel, market share and industry expertise around the world, the politically-imposed restrictions on auditor choice due to outmoded concepts of independence, and the post-Andersen fragility of the large firms’ networks, combine to show that a four-firm structure is irreducible.

As the catastrophic impact of rare but devastating “black swan” events makes clear, it only takes a single one.

 

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Comments

[Bert T. Edwards, CPA, CGFM, CGMA]

This a interesting white paper. Among issues not covered are (1) a four-to-three redistribution of clients is infinitely more complicated due to conflict-of-interest issues (among large companies in the same industry, consulting work done by a potential new firm, important portions of an international auditee located in a country which is not served by any of the "final three", the largest multi-national auditees' inability to engage a competent replacement firm, etc., (2)the well-accepted complication of an initial audit expense, (3) nationalistic regulations on licensing new offices of a "final three" successor firm, (4) inability of audit functions in states, the GAO, and international audit offices to conduct a GAAS audit (already in the US, US States and larger cities are moving/have moved to using private CPA firms and the focus of many international audit functions on operational audits vs. financial audits, etc. In the post-ENRON era, many observors believe the "final four" (to use a basketball term)have survived an audit issue equal to or even greater than ENRON since it did not make any sense to contract the choices available for a change. Unintended casualties might well be the abandonment of the market of insurance of any type on surviving say top 20 firms that are currently expanding via acquisitions. Auditor rotation for many auditees will become impossible if that movement gains support world-wide - it is already tough enough for a large auditee to change!

[Jim Peterson]

Bert - Thanks for your thorough and incisive comment. You are dead-on several critical issues that are essential to an adult dialog around the viability of the current Big Audit model; space constraints limit fuller treatment here, but they are all addressed in my blog archive.
By the way, "final four" is a terribly inappropriate term -- as the NCAA tournament comes down to a single survivor. If a sporting metaphor is needed, "Russian roulette" is more suitable.
Jim

[Henry Motyka]

Brings back memories of what happened at Coopers & Lybrand when a bad audit of a disk drive manufacturer almost brought down the firm.