Re:Balance -- Jim Peterson

Up-Date from the UK Audit Regulator: The FRC’s Skipper Jumps Ship

Stephen Haddrill, beleaguered chief executive of the Financial Reporting Council, the audit regulator in the United Kingdom, is reportedly to debark by the end of the year.

No surprise. Haddrill has been a marked man since early this year, his agency targeted in Parliament as “toothless”, “useless” and “ineffective” amid an outbreak of outrage over the collapse of the construction group Carillion, the massive hole revealed in the pension fund of BhS with its collapse post-sale for £ 1 by Sir Philip Green, and its own endless inquiry into HBOS.

A raging tempest of official inquiries into the provision of financial statement assurance for large public companies extends to both the market-dominating position of the Big Four – Deloitte, EY, KPMG and PwC – who collectively audit all of the FTSE 100 and 97% of the FTSE 350, and the structure and efficacy of their oversight.

“Thrown under the bus” would be apt.

Or – to provide historical perspective for those curious about the inevitable back-story -- consider that the modern audit function was invented in the Victorian era, while ships of Her Majesty’s navy were enforcing Pax Britannica by flying the Union Jack around the globe. To invoke the nautical metaphors:

• Is Haddrill making his jump ahead of an inevitable walk of the plank or swing from a yardarm?
• Is he merely the first rodent to debark a leaky and sinking ship?
• Are the FRC’s own proposed “solutions” yet further exercises in re-arranging the Titanic’s deck chairs?
• Or is Haddrill just an earnest but hapless cabin boy, while a mess of squabbling brass-hats blithely sail toward the rocks while resolutely steering by the wake?

If none of these will serve, perhaps the sardonic observation of Voltaire’s Pangloss, that it may be necessary to shoot the occasional admiral, “Pour encourager les autres.”

That is because the degree of justifiable criticism and public distress over the fitness for purpose of the current Big Audit model remains unmatched by clear-eyed awareness of the lack of either achievability or beneficial impact on the perceived issues.

That is, concerns over market competition, concentration and audit quality have elicited a “wish list” that includes splitting up the Big Four, forcing them to divest their non-audit services, mandating joint appointments, turning over the auditor evaluation and selection process to official authority, and even forcing reduction of the Big Four’s dominant market share.

But as examined here in an on-going series begun last month, there is nothing good that can come of any of these, but only disruptive and ineffective adverse consequences. Nor will poor Stephen Haddrill’s rowing away into the sunset have any good effect at all.

 

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Regulators' Re-Work of Big Audit? – “Joint Audit” Is Another Non-Starter

Today’s topic is “joint auditors for large companies” – continuing a series from September 25 through October 8 and October 16, on the issues involving Big Audit that confront the regulators and politicians in the United Kingdom who seem determined to impose disruptive change.

Along with cultivation of smaller firm participation, proposals reflected in papers issued by the Financial Reporting Council and the Competition & Markets Authority and political pronouncements from both parties include break-up of the Big Four, forced separation of their non-audit services, auditor appointment by government authority, and voluntary reduction of their 97% share of the FTSE 350 market.

The optimistic case that encouraging or requiring joint audits might beneficially affect audit quality or increase the competitive access and capability of smaller firms to perform large engagements is found, e.g., in the CMA’s paper, ¶¶ 4.18-.22. There are three challenges -- each distinct and sufficient: capacity, quality and risk tolerance.

Capacity

On the ability of the smaller firms to gain market share, to affect competition and auditor choice, look to the French market, where joint auditors are required. Companies in the CAC 40, France’s large-company index, primarily choose two Big Four firms. The only smaller firm with any index-level participation is Mazars – fifth ranked in France, ninth in the UK and 14th globally. Its 2017 global revenue of $ 1.68 billion is approximately seven percent of the average revenue of the Big Four.

At that size and scope, Mazars has little reasonable prospect of taking on a FTSE 350 engagement, much less one in the FTSE 100. However beneficial its experience in France, Mazars has not grown the capability to obtain and share a joint audit with any of its smaller brethren, whose limitations would if anything be more acute.

On the capacity issue, in short, the French market experience has spoken with eloquence.

Quality

The proposition that joint audit contributes positively to audit quality suffers the familiar challenge of a small sample size and a lack of empirical support. While a research project awaits the attention of a curious scholar, historical experience supports the opposite.

Most recently, in the years under scrutiny for the € 200 billion laundered without discovery or disclosure through the Estonian branch of Danske Bank, the bank’s annual reports show that its audit was done jointly by Grants and KPMG for 2007-2010 and PwC and KPMG for 2011, before one-firm takeover by KPMG for 2012 and 2103, EY for 2014 and finally Deloitte for 2015 onwards.

Five years of joint audits, in short, were no more effective by way of detection or prevention than performance by a single firm.

As a brief sidebar on a related subject, the rotation at Danske through five different audit delivery models over nine years does no favor to the “fresh eyes benefit” urged by the proponents of frequent and mandatory auditor replacement.

There is history. Back in 2003, Deloitte and Grants had shared the audit of Italian dairy conglomerate Parmalat. Disclosure of a € 20 billion hole in its accounts revealed the mechanism: bogus contracts housed in an account labeled the “buco nero” (“black hole”) – colorfully evocative although insufficient to entice preventive inquiry by either or both.

As a precursor, the great Ponzi scheme of the 1970s run at Los Angeles-based Equity Funding involved the separation of audit responsibility between Haskins & Sells, as it was then branded in the US, and a small firm recently joining the US operation of what is now BDO. At the heart of the criminal scheme was concealment from both firms of the creation of whole ledgers of non-existent holders of fictitious life insurance policies.

To summarize, division and sharing of audit responsibility with its challenges of communication and administration brings the risk of cracks through which problems and manipulations may fall undetected.

Risk Tolerance

To conclude, the professional auditing standards permit the division of work between two or more firms (see the PCAOB’s AS 1205 in the US, and ISA 600 as widely adopted elsewhere).

In practice, the principal auditor judges whether and how to make reference to the other auditor (ISA 600.11 and AS 1205.04-.09). Either way, while the choice has implications for the level of responsibility assumed by the other auditor, the principal auditor retains responsibility for the entire scope of its own work – including the adequacy of its reliance and delegated decision-making.

There is the bind, in jurisdictions such as the US where “joint and several” legal liability exposes auditors to 100% of the potentially devastating consequences of a breakdown or failure. Inadequate as the financial resources of a Big Four firm are to protect itself from a deathblow lawsuit, the ability of a smaller firm to assume a meaningful share, monetarily or by percentage, is immaterial.

That limitation assures that the risk-management evaluation of a Big Four firm as principal auditor, persuaded or obliged to share a large audit, will include the time and attention of a full-court press on the actual performance by the smaller firm – involving substantial duplication or overlap and negative consequences for the achievability of cost efficiencies or real sharing of experience or expertise.

Conclusion

There continues to be no sign of official awareness, that none of the proposed “solutions” to the perceived issues around Big Audit is feasible, achievable or capable of affecting audit quality or competition – a fact so far without impact on the public discourse.

Joint audit, among them, is another “non-starter.” Which reinforces the suggestion here that, sooner or later, the intrusion of reality into the discussion should become compelling.

 

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Re-Allocating the Big Audit Market in the United Kingdom – Or Perhaps Not

"Two aristocrats are out horseback riding and one challenges the other to see which can come up with the larger number. The second agrees to the contest, concentrates for a few minutes, and proudly announces, “Three.” The proposer of the game is quiet for half an hour, then finally shrugs and concedes defeat.”

     -- Mathematics professor John Allen Paulos, “Innumeracy” (Hill & Wang 1988)

Regulators and politicians in the United Kingdom may well disrupt the Big Audit model – judging from inquiries launched recently by the Financial Reporting Council and the Competition & Markets Authority. The series that began here on September 25 and October 8, started to address the misguided nature of the purported “remedies.” It is making for pretty heavy going – so with thanks for the opportunity to write this as guest for Going Concern, this to lighten things up a bit.

Grave as are the UK threats to break up the Big Four, strip them down to “audit only” or impose government appointment of large-company auditors, it would take a comedy script-writer to capture the folly by which, it is suggested, the Big Four would “voluntarily” reduce their dominant market share of the FTSE 350 from 97% to 80%.

The head of assurance for Grant Thornton in the UK offered on September 14 that a nationalized appointment authority, which “would take the buying decision from the company … could split audits, say 50 for the Big Four and 50 for the non-Big Four.”

Seriously intended or not, the idea comes oddly from those with expertise in the assessment and comprehension of quantitative information. What comes to mind instead is the stateroom scene in “Night at the Opera.”

To expand and explain -- by 2017 revenue, the ten large firms in the UK array as in the table below (in £ millions). Of their £ 13 billion total, the Big Four garnered over £ 11 billion or 86%. The trailing six firms divided the remaining 14%.  

PwC	3,598
Deloitte	3,380
EY	2,350
KPMG	2,172
Grant Thornton	500
BDO	429
RSM	320
Moore Stephens	181
Mazars	173
PKF	130

If the notion of shifting fully half of the FTSE 100 audits were apportioned by firm revenue, Grants would take fifteen, BDO twelve, RSM nine, and each of the others four or five.

Collectively, how ready and capable would they be? BDO presently has only one such engagement -- Randgold Resources Ltd – actually on the bubble at # 101 -- and that one is likely to go away with the September 25 announcement that the company is to be acquired by Barrick Gold Corp, an audit client of PwC in Toronto.

Grants itself once had a FTSE 100 client, until the stock price collapse of Sports Direct dropped its ranking to # 181. And in any event, that job is to move with the upcoming displacement of Grants thanks to the UK’s mandatory tender and replacement rules. None of the other mid-size firms audits a FTSE 100 company.

As graphically displayed here on September 25, the impact of scale is critical. No number of hours at the controls of a single-engine airplane can qualify a pilot, however skilled, to command a wide-body jet – much less a helicopter or a space shuttle or a stealth drone.

No less, and without a whisper as to the relative work quality up and down the table, the requirement of experience at the Big Four level in performing large-company audits with global footprints and necessary industry expertise is compelling.

So despite the reams of paperwork that will be generated through the inquiries of the UK regulators, it remains a solid certainty that nothing like the suggested 50/50 re-allocation of the FTSE 100 will ever happen.

Sooner the proponents, like Professor Paulos’s mounted aristocrat, eventually “shrug and concede defeat,” sooner the discussion can move to steps of possible achievability and beneficial effect.

 

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Dominance in the Big Audit Market – Reality Meets Its Critics

"The girls all get prettier at closing time….”

             --Mickey Gilley, 1976 (lyrics by Baker Knight)

A series began here on September 25, to look at the agitation in the United Kingdom around the Big Audit model, and the proposals mooted by regulators, politicians, the government's Secretary of State for Business, and the accountants themselves, by which the dominance of the Big Four would supposedly be addressed.

Proposals include split-up of the Big Four, stripping the firms’ ancillary services to reduce them to “audit only,” joint audits with smaller firms, government assignment of engagements, and voluntary reduction of their 98% share of the FTSE down to 80% or, as urged by the Financial Times on September 2, even as far down as 60%.

That introduction looked at a graphic display of the Big Four’s market share – illustrating the impracticality of this array of so-called “solutions” -- at least so long as the world’s capital markets desire the survival of the current model of privately-provided assurance on the global financial statements of the world’s large companies.

Focus here on the achievability of a market share reduction. The FT on September 2 cited Barclays as a “prize” engagement to be taken up by a smaller firm. So consider the simple question of choice-making, and try to imagine a cohort of civil servants charged to evaluate competing proposals to succeed incumbent KPMG.

Of the total 2017 revenue reported by Barclays PLC for 2017, about two-thirds or some £ 14.4 billion was reported in the non-UK operations of Barclays International, conducted through 40 “main entities” in 22 different countries.    

Assume for the nonce that the Financial Reporting Council achieves a sufficient vote of confidence to survive the pending calls for its abolition or wholesale re-working as the UK’s audit regulator. If it is to be the appointment authority, would its remit run to the UK only? How would it address the global challenge that large UK-based companies derive only some 25% to 30% of their revenue inside the country itself?

Suppose the FRC engineered a UK-only shift of Barclays to a smaller firm – which would face the dazzling complexity that two-thirds of the client's operations are foreign-based and must be audited abroad. What would be the realistic likelihood of successful administration and integration of the multi-country non-UK work if still done by KPMG, into and along with the local reporting on the bank’s UK and headquarters operations?

Or, alternatively, suppose the FRC were bold enough to insist that a smaller firm’s global report and opinion would only be compliant if supported by the work of its own ex-UK member firms. All aside from the political challenges of forcing that decision down the throats of regulators around the globe, there would be the impossible challenges to the smaller firms competing for the job, to demonstrate a satisfactory breadth of geographic presence and expertise.

Of no less importance, the FRC itself would require the competence to scrutinize and compare the qualifications of the small firms and their competing applications, including their relative competence to audit complex international banking operations in countries speaking perhaps nine difference languages and using some fifteen different currencies.

The realistic prospects for the required army of functionaries are non-existent. Examples of dubious regulatory choice-making are all too common, and need not go beyond the current criticism of the FRC itself, to raise doubts about the ability of a government agency to supplant the "auditor choice” function now performed by corporate audit committees in the exercise of their own mandated duties.

On a related front, what is the likelihood of any beneficial impact from an attempted reduction in the Big Four’s dominant market share of the FTSE 350?

To start, what is meant? What metric would apply to measure a reduction to 80%, or 60%?

The FRC might seek to enforce auditor choice based on a financial basis. If so, observe that the FTSE 100 and 250 together have a total market capitalization of £ 2.448 trillion. A 20% shift in market share to the smaller auditors would involve re-assigning a portfolio of companies with aggregate market cap of some £ 490 billion – while a 40% share would involve some £ 979 billion.

The scale issue promptly enters, because corporate size, like that of the accounting firms themselves as graphically displayed, is distributed on a “hockey stick” basis. That is, of the total market capitalization of the entire FTSE 350, it takes only the 70 largest companies to make up 80%, while the companies making up 60% reaches down from BP as the largest only so far as Anglo American at number 25.

Practicality now screams at high volume. For firms outside the Big Four to audit a mooted 20% of the FTSE 350, by market capitalization, they would need to take up the audits of all the index companies smaller than about number 71 – an over-whelming total of some 280 engagements.

Or suppose the FRC were to pursue its goal by number of companies only. To move 20% of the 350 might mean displacement of about 70 audit mandates. Suppose briefly that the choice process would focus on the smaller end of the scale (a topic for further inquiry in any event). The total market capitalization of the 70 companies at the lower end of the index is about £ 60 billion. That, for context, makes up about 2.5% of the index total. To shift that number of engagements, for all the cost and disruption involved, surely has the appearance of a goal not worthy of the effort.

Moreover, audit experience and competence are not fungible across industry sectors. The issues and the demands differ, for example, as between banks and hotels and consumer products. By market cap or simple numeric measures, or any other metric passing a test of rationality, the proponents of the “market share reduction” proposition -- trying with straight faces to sell the notion that either competition or audit quality would be beneficially affected – should be obliged to demonstrate the availability of the resources by which the FRC could hope to carry out its charge, and the smaller firms could hope to achieve and demonstrate anything remotely like the necessary capability.

On both, skeptics are waiting.

Meanwhile this series will continue. 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 at the Main page.