A Fresh Year, Fresh Problems, And A Fresh Look at the Big Four’s “Tipping Points”

Financial malfeasance has started this New Year with a bang.

Two bangs, actually: on January 17, Rolls-Royce admitted to a twenty-year history of corporate bribery on a global scale, for which the first level of its penalties includes guilty pleas, deferred prosecution of multiple felony charges, and fines of £ 671 million to authorities in the UK, the US and Brazil; and on January 24, the trebling to £ 530 million of the previously announced cost of irregularities in a business at BT Group’s Global Services in Italy that last year had less than £ 100 million in earnings -- knocked 19% or £ 6 billion off BT’s shares in a single day.  

Shareholder plaintiffs are off to the courthouses, and once again the cry is heard, “Where were the auditors?”

While litigation results and answers will emerge in due course, new problems this big call for the re-visit of an old topic. Starting back in 2006, and in updates since, I have compared the “worst case” litigation risks faced by the Big Four accounting firms with their capacity to withstand a shock on the scale of Enron’s fatal impact on Arthur Andersen in 2002.

The inquiry is neither pleasant, nor the insights attractive. But there are two reasons for the attention:

First, Big Four growth has driven their combined global revenue near $ 128 billion for fiscal 2016. But nothing since Andersen fell makes the capital-thin balance sheets of the surviving tetrapoly any more robust against an outcome of similar “black swan” magnitude.  

Second, intense criticism continues, over the roles and performance of the international networks that provide audit services to virtually the entire population of the world’s large public companies. A sampling, just in the last year:

• The SEC and other global regulators are up in arms over the widespread practices of public companies to report financial results in their own favor, using “non-GAAP measures” – that is, techniques other than Generally Accepted Accounting Principles.

• The SEC landed on EY in September for two different independence violations, based on inappropriate relationships between audit partners and client financial executives.

• In December the PCAOB blistered Deloitte, for admitted alteration of documents and false testimony by its personnel in Brazil, along with separate lesser proceedings in Mexico and the Netherlands.

• And the events at Rolls-Royce and BT Group only refresh the list of adverse corporate behaviors recently including Valeant, Wells Fargo and Toshiba.

To re-cap – in September 2006 the consulting firm London Economics reported to the EU markets commissioner, using a model that tested the threat to the viability of a large UK accounting firm – based on the finite tolerance of individual partners for personal financial sacrifice, before a critical number would withdraw their capital and throw a firm into a death spiral.

Assumptions and scenarios in the model included the impact of a crisis environment on reputation, revenue and profitability, and hypothetical take-home reductions for the partners of from fifteen to twenty percent and extending over three to four years.

Extrapolating the UK model out on a global basis and up-dating for current numbers, the Big Four “tipping points” can be calculated – today suggesting the risk of potential disintegration at between four and six billion dollars.

Calculations at the global level are only first steps, however. That is because as in 2002 with Andersen – whose profitability and global cohesion exceeded any of its peers, yet fell apart in a matter of weeks – the destabilizing forces of a multi-billion dollar imposition surpass the ability of these networks of individual partnerships to maintain their global integrity and mutuality of support.

Instead, the threat was on plain display in August 2016, when PwC’s US firm confronted damage claims of $ 5.5 billion dollars, brought in Florida by the bankruptcy trustee of the mortgage underwriter Taylor Bean & Whitaker, relating to the firm’s audits of Colonial Bank, the sixth largest American bank failure coming out of the financial crisis of 2007-2008.

Unable to resolve the lawsuit in advance of trial, PwC endured three weeks of courtroom hostilities before reaching a settlement. The amount was undisclosed and still confidential – within the firm’s capacity but surely large enough to be painful both fiscally and organizationally.

With exposures in the US both the largest and the most likely, among the world’s large economies, single-country calculations are needed – where under the London model, break-up numbers for the America-only firms shrink from about three billion down to a truly frightening figure below one billion dollars.

Relevant factors[1] include:

• The context of the last decade in which litigation outcomes have escalated far beyond the firms’ ability to respond.

• The reasons why and how the business models of the Big Four, contrasted with the banks and other big-dollar defendants, can operate with levels of capital so limited that their viability can be threatened at such derisory levels.

• The irrelevance of the role of insurance at the levels of existential threat, either in the commercial marketplace or within the Big Four structures themselves.

The punch line is the same as when first raised a decade ago – a critical lesson from the collapse of Andersen that has not been learned:

The loss of another Big Four firm would throw the entire Big Audit model into chaos, for want of replacement choices and the unwillingness of the three survivors to stay in an unbearably risky business.

Instead, the Big Four are down to their critical minimum. The present four-firm structure is irreducible, given the uneven concentrations of their personnel, market share and industry expertise around the world, and the politically imposed restrictions on auditor choice due to outmoded concepts of independence.

If one more goes down, they all go down. So the stability of the entire wobbly structure rests on the continuing survival of them all, including the weakest.

And on that lesson is where real concern should rest.

Coming up: What would be the impact if the regulators got their wish – if the Big Four split off their Advisory and Audit practices? “Déjà vu” all over again?

 

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[1] Readers are invited to more detailed treatment in my earlier posts of January 6, 2015, and November 30, 2011, and my book on the fragility of the large-firm audit model -- “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” published by Emerald Books in December 2015.

Comments

[Mike]

GT, RSM, BDO and PKI can step in.

[Jim Peterson]

Thanks Mike. Unfortunately -- can't happen. It's a matter of scale and risk tolerance. For 2016, KPMG -- by a good bit the smallest of the Big Four -- had global revenue of $ 25.4 billion. BDO - $ 7.6, RSM - $ 4.6, Grants - $ 4.6, PKI about $ 1. If magically (and impossibly) those four combined, they would still be dramatically smaller than the smallest. Neither alone nor together could any of them take on the audit of the large global public companies, if offered on a silver platter -- as their risk managers would confirm (if only off the record).

[David Damant]

The fact that there are four big accounting firms and not six is entirely the fault of the regulators. When Arthur Anderson fouled up with Enron there was no need to bust the whole world wide firm. And the merger of Price Waterhouse and Coopers should never have been allowed. David Damant

[Jim Peterson]

Thanks David. There are complexities the history of both Andersen's collapse and the merger that created PwC, that would expand your comment -- the challenge now being the fact that the surviving Big Four are down to "critical mass."