If The Big Four Went “Ex-Advisory” – Déjà Vu? Or Worse?

Will this be the year that history repeats -- when the Advisory practice of one or more of the Big Four breaks away from Audit? What would a reprise look life, of the withdrawal from consulting they made between 1998 and 2001?

The inquiry is of interest, to the firms' partners, employees and clients -- and not least to all users of the audited financial statements of the world’s large public companies.

The conditions are all present, and ominous, for two reasons.

First, taking the various regulators at their word, they have a distinct distaste for the growth of Big Four “Advisory” -- as consulting is now cosmetically re-labeled. In a Washington speech on December 9, 2013, PCAOB chairman James Doty observed that:

“We have, in recent weeks, seen publicly reported examples of a resurgence of audit firms into consulting to bolster revenue. Of what consequence are these developments for the audit function? What are the implications for independence of the audit function? ... What are the risks of other business lines and how do they affect resource allocation and investment in audit?”

In the same vein, PCAOB member Lewis Ferguson, in his then-capacity as chair of the International Federation of Independent Audit Regulators, was quoted at an IFIAR press conference on April 10, 2014, that the auditors’ search to acquire expertise in Big Data and its applicability to auditing “is a source of great concern to all regulators around the world,” and “raises serious concerns about differential levels of profitability in these businesses, differential rates of growth, where the economic incentives are and to what extent does audit quality suffer as a result” (emphasis added).

Second, the bureaucrats’ antagonism aside, there are sustainability implications in the continued growth rate disparities between practices. Audit revenue growth for the Big Four is stagnant in the low single digits, while their Advisory practices continue the trend of recent years, positive in the mid-teens.

As a model for the evolution of the practice mix of the large firms, Deloitte’s 2016 Advisory revenue, according to its global annual report, was absolutely $ 3.5 billion larger than Audit; its Assurance and Tax together only measured above 50% of its global total by including Risk Advisory on that revenue line.

Memories long enough will recall the large firms’ various exits from their consulting businesses, with their unfortunate capitulation to the regulatory and political pressures on permissible scope of ancillary services to audit clients:

• EY’s sale to CapGemini in February 2000.

• KPMG’s 2001 spin-off to create what became BearingPoint.

• PriceWaterhouse’s sale of its practice to IBM in July 2002.

• Most especially, the bitter and avoidable divorce between Arthur Andersen and Andersen Consulting, commenced in 1998 and finalized with the launch of Accenture on January 1, 2001.

Despite Andersen’s cohesion, profitability and market position – never matched even in the dreams of its peers -- its leaders were unable to overcome their structural stresses or resolve the issues of client service constraints, disparate profitability and allocations of authority and governance influence.

With the internal, regulatory and litigation pressures all mounting today, it is both too easy, and thoroughly dispiriting, to imagine a repeat – one that for all the public may know is percolating even as we speculate.

It is, to say, not difficult to picture a quorum of unhappy non-Audit partners, delivering ultimata to their leaders that demand structural revisions to compensation packages and promotion incentives and organizing documents. Meanwhile, other dissidents would be lawyering up and engaging teams of bankers to model the costs and opportunities of a practice line break-up or break-down.

Since the plausibility and possibility cannot be ignored, what would the model for Big Audit look like, if delivery were soon to be done by four firms comprising audit and tax practices alone?

First of all, Big Four rankings on a 2016 “audit and tax” basis would be (in US $ billions): PwC - $ 24.4; Deloitte - $ 20.4; EY - $ 19.05; KPMG - $ 15.7. The revenues of their US practices would array between $ 6.6 and $ 9 billion.

One element at the heart of the concerns is that of fragility and survivability. For this, the analysis is pertinent that I have done here in the past – calculations of the financial “tipping points” – that is, the size of a “worst case” litigation or law enforcement outcome that would destabilize and disintegrate a Big Four network.

No fun – although necessary in any grown-up discussion of what such a model for Big Audit might look like – that analysis yields indicated break-up numbers well below $ 1 billion. That is hardly enough to register, in an environment where VW has agreed to pay out some $ 22.5 billion to resolve only the US portion of its penalties for its diesel emissions “defeat” software; with Rolls-Royce’s penalties for twenty years of global bribery to include £ 671 million in fines to authorities in the UK, the US and Brazil; and where disclosure of the cost of irregularities in the Italian business of BT Group knocked the company’s value by over £ 6 billion in a single day.

These are figures disturbing enough to give serious pause. But even as the atmosphere of denial on this subject prevails, there are also disturbing implications for the ability of these reduced organizations to serve the assurance needs of the world’s capital markets. That is, as the case for the traditional “pass/fail” auditor’s report continues to erode, the prospect of reviving its value by “shrinking to success” would look increasingly dubious.

Here the concern is about the ability to evolve, when the personnel who would leave with the departing Advisory practices would strand the auditors without the support of such diverse talents as the data analysts and software designers, engineers and robotics experts, economists and lawyers and bankers alike – expertise lured away in a repeat of history by the enticements of unfettered stand-alone Advisory opportunities.

Both regulatory hostility and diminished professional capabilities would challenge the ability of an “audit only” Big Four to respond to the implications of the inevitable. The genie of change is already recognized as out of the bottle, and will not be returned. If the audit firms handicap themselves with a failure to stabilize, evolve and maintain truly full-service structures, business models and methodologies accordingly, then new players to serve the market’s demands surely and shortly will appear.

So – is another Audit/Advisory split on the horizon, with all the unpleasant consequences? No prediction is made here – but under today’s conditions, no bet against it either.

 

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Comments

[Tom Rudibaugh]

One query: Are you certain that tax would stay with audit v. pushing to be added to advisory services practice and also pull away from audit?

[Jim Peterson]

Thanks Tom -- Where a tax practice might go in a Big Four break-up would be hard to predict, not least because the dynamics are in tension. The tolerable association of tax compliance with audit is so long-standing, even though inconsistent with both the theory and the pressure for audit-only, that it might prevail. On the other hand, regulatory attitudes in the EU, for example, are pressing in favor of purer "audit-only."
Meanwhile, as I have written here and as treated in my book, my own view is that the entire body of scope-of-service restrictions is obsolete and anachronistic, and that independence constraints should simply be abolished -- an unconventional position, I know, but one that structural changes in the Big Audit model will sooner or later put to the test.