Re:Balance -- Jim Peterson

Re-Work the Big Four Audit Market Share? A Single Graphic Shows "No Way"

Glendower: “I can call spirits from the vasty deep.”

Hotspur: “Why, so can I, or so can any man;
               “But will they come when you do call for them?”

            -- Wm Shakespeare, I Henry IV, iii, 1

Can concerns over the suitability of the Big Audit model be addressed by forcing the large firms to shrink their dominant market share – or any of the other "solutions" mooted in the UK by regulators and politicians?

Abetted by the ICAEW, the Big Four floated last month a readiness to reduce their 97% share of the FTSE 350 to 80%. Not good enough, said the Financial Times on September 2, plumping for 60%.

The last year has seen multiple renewals of the perpetual question, “Where were the auditors?” Colonial Bank – Carillion – Danske – Gupta – Steinhoff – ImdB – the examples circle the globe. In London, hostile critics are circling -- fairly salivating at such notions as breaking up the Big Four, stripping them of their ancillary non-audit services, or nationalizing the selection and assignment of large-company engagements.

A blunt truth, for those desiring to maintain the current model of private assurance on the global financial statements of the world’s large companies: none of these can be achieved in a non-disruptive way, nor would they touch either competition or quality, except to be seriously detrimental to both.

To start what will become a series -- the topic being too complex to cover in a single go – there is the simple matter of scale. This graphic[1] arrays ($ millions) the 23 international accounting networks with 2017 global revenue above $ 200 million – from giants Deloitte and PwC at $ 38.8 and $ 37.7 billion down to the $ 361 and $ 207 million of Asia-based ShineWing and UC&CS of Latin America.

The visual message is simple and stark. No network smaller than the Big Four has a prayer of achieving the scale and resources to clamber into a competitive position.

The importance and impact of scale show a fatal flaw in the “market reduction” proposition -- displayed right there on the familiar but under-appreciated “hockey stick” curve. Other examples abound:

• Earthquake damage: there are countless harmless daily tremors, while the exceedingly rare catastrophes are devastating.

• Book sales: a handful of blockbuster authors – J.K. Rowling, Dan Brown, Bob Woodward – overwhelm both the modestly successful and the long tail of unread dissertations and self-publications.

• Destructive weaponry: the number of nuclear weapons is small but existentially threatening, scaling down from warships and assault helicopters to the local impact of hand-carried firearms, clubs and spears.

Not only does scale matter – its impact is exponential. The two largest of the Big Four are ten times the size of numbers nine and ten – and one hundred times the size of the two at the far right.  

The issue need not assume quality differences. Hosts of talented but struggling and unemployed actors and musicians and athletes wait on tables and hustle ride-shares, while a handful of super-stars get the plum jobs and sign the extravagant deals. In the 16^th century, the small cohorts of Pizarro and Cortés with their Spanish arms, armor and horses subdued the entire Incan and Aztec empires.

On the same core principles -- no amount of best-quality experience auditing community banks and retail brokers and owner-operated corporations can equip any of the thousands of small-network auditors with the credentials, expertise and geographic presence to take on the engagement of a Barclays Bank or a GlaxoSmithKline.

Those examples are cited deliberately. They are urged by the Financial Times as among the “prize mandates,” whose audit committees under a re-engineered model “can as easily appoint an auditor from outside the Big Four as they currently do from within.”

Perhaps not. Shift from the visual to the verbal, with a look at Barclays’s 2017 Country Snapshot. That report, on the global tax position of the UK’s second largest bank by assets and ranked 17th by market capitalization in the FTSE 100, examined and reported on by KPMG, covers 36 countries where the bank’s local turnover ranges from £ 13 billion in the UK down to £ 10 million, plus an additional ten countries below that cut-off.

The scope of KPMG’s tax report, laid out in its footnote, displays the auditor’s obligation to provide holistic global capabilities -- among other matters, to address “which entity to report activity under,” and intra-group eliminations that “include dividend payments, income from intra-group transfers of assets, and income rising from hedging transactions….”

Against those broad needs, an admittedly non-comprehensive sample looked at the publicly-disclosed resources of the four international networks that rank ## 7 through 10, as reported for the ten countries above the Barclays materiality cut-off. Some reasons emerged for possible concern:

• Many of the firms bear the single name or are still under the first-generation leadership of a founder – suggesting at least a question of maturity.

• Several firms disclose that management and service delivery in their locally-listed offices are coordinated regionally or from ex-country locations.

• Of those showing local personnel numbers, a count of five or fewer partners is frequent – several with no more than one or two in the assurance practice.

• And in the disclosures of industry sector or audit practice capability, banking is almost never included.    

Emphasizing again, these challenges take no position on any relationship between size and quality – only that the demands of complex multi-country engagements will outstrip the capabilities of networks locally comprising a small-country client base and limited personnel resources.

Coming installments here will go deeper: the impossibility of nationalizing audit assignments; the fallacy that “joint audit” could be a realistic springboard from which a small firm could vault up to an upper tier FTSE-indexed engagement; and the question, if the Big Four were to surrender clients, just who would choose, and how.

For now, it ought to be clear that neither wishing nor complaining, however loud and passionate, make for achievable policy.

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[1] Source: the International Accounting Bulletin

Blockchain and Bitcoins – Notes From the Sidelines

"Know when to hold ‘em, know when to fold ‘em.”

           -- Don Schiltz, “The Gambler,” 1976, Kenny Rogers's hit in 1978

“You work with risk all the time. What’s the deal with blockchain and bitcoins?”

I have long resisted these invitations. But enough reader inquiries prompt some thoughts – mostly skeptical and cautionary.

To start, I claim no expertise. Nor do I presume to offer recommendations from the fulsome library of available literature. That’s because I am a dedicated observer of the Dunning-Kruger effect, especially its most trenchant real-world application – that the less you know about a complex subject, the more likely you are to commit grave decisional errors based on a combination of ignorance and over-confidence.

My students in Risk Management love Dunning-Kruger. For homework they identify cases where the effect was handled either well or poorly. An example of my own was the decision to part company with a financial advisor, after I had done enough inquiry to appreciate that he knew no more than I did about the then-volatile state of the state of a market bubble.

The literature is wide and varied, in substance and quality. To those inspired to delve into either blockchain or the grab-bags of bitcoins – please be skeptical enough to resist believing that wisdom comes from those seeking to sell something, including advice.

Here then are a few things I believe I know:

One is that blockchain – very briefly, the recording of bi-party transactions on a secure and anonymized distributed ledger – will be transformative, highly disruptive and immensely valuable.

Why? Because leaps of this scale and long-term effects are rare but real. Think of the railroads – human flight – the transistor – and yes, the iPhone. Also more to this topic, the hugely reduced customer transaction costs and information arbitrage in such knowledge transfers as negotiated Wall Street fees and self-booked airline tickets, Uber and Lyft and Airbnb.

Where, when, and which players will emerge as winners? Too early to tell. There is no reason to believe that “Amara’s law” will not apply. That observation, hardly a “law,” is empirically observed -- basically, that the effects of a new technology are over-stated in the short run and under-stated in the long. (Compare the lift-off and flameouts of Webvan and Pets.com two decades ago with the current explosive growth of Instagram and WeWork.) At this early state of blockchain’s evolution it would be futile, and potentially very costly, for an amateur to try to pick the likely surviving successes.

As for Bitcoin and its coevals, JPMorgan Chase CEO Jamie Dimon’s characterization was of “a fraud…worse than tulip bulbs” -- which he only slightly walked back to say, “if you’re stupid enough to buy it, you’ll pay the price for it one day.”

It is observable that bitcoins fail to date to meet the definition of “money” – none of them satisfying all three conditions: a stable and widely-accepted unit of accounting, a medium for exchange transactions, and a credible store of value.

This does not de-legitimize their inclusion in the world of commodities, where trading markets and exotic financial instruments are based on everything from jet fuel and gold to pork bellies and orange juice concentrate. Except that for these and others, zero-sum trading eventually depends on real end users – whereas crypto trading markets and prices are hostage to a continuously-renewed supply of credulous new participants, to replace those busted out and left nursing their losses and their regrets.

It is true that the entire crypto adventure has transferred considerable real money from the later arrivals to the earlier, although the dramatic Bitcoin price run-up to nearly $ 20,000 last December, and its precipitous fall below $ 7000 last week, left many of the later sheep shorn to the buff. And the earlier punters, now optimistically holding onto unrealized gains, are at the mercy of price fragility with the refreshing supply of “greater fools” apparently dried up.

As for those looking to profit from the infrastructure of crypto trading, I invoke a family relative, a 19^th century entrepreneur who made a fortune out of the California gold rush, not by prospecting or investing in the mines or claims, but by founding an import business to store and sell extravagantly priced fruits and vegetables to the miners and their camp followers. He did very well out of his customers’ pockets – like today’s authors of “how to” manuals on day-trading, as well as casino operators and sellers of lottery tickets.

A note in closing, to warn of the hazard built into the entire crypto universe, as third-party transaction support, custodial services and financing sprout up around the original world of two-party contracts.

That is, history is replete with schemes, sure to emerge with crypto’s evolution, that inhere in the ability to falsify and double-count inventory, multiply the pledging of collateral, and monetize fictitious client assets – from the bogus customers of Equity Funding and the Salad Oil scandal with its storage tanks of water five decades ago, to the unconfirmed mortgage portfolios at Colonial Bank in recent years.

As Citigroup CEO Chuck Prince put it colorfully in July 2007, only months before losing his job when the party ended at the bank, “as long as the music is playing, you’ve got to get up and dance.”

For myself, if all the same, I’ll be sitting this one out.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both on the Main page.