“Join a poker game not knowing who the patsy is – then you’re the patsy.”
-- Gamblers’ maxim
The UK’s Competition & Markets Authority delivered a sack of coal as its holiday gift to the capital markets -- its December 18 “Statutory Audit Services Market Study”. Especially dubious is its proposal (¶¶ 4.26 et seq.) to require joint audits of the country’s large public companies.
Now 97% audited by the Big Four – Deloitte, EY, KPMG and PwC – the FTSE index companies would instead be expected to welcome the imposed addition of firms from down the league table.
If there is any benefit in dividing responsibility between audit firms of any size, for either competition or audit quality, the evidence lies somewhere between scantily ambiguous and seriously negative (see here from October 24, and the egregious experiences of Equity Funding in the 1970s, Parmalat three decades later, and Danske Bank today).
A more practical issue is one of supply. The CMA assumes with Panglossian naïveté that what it optimistically calls the “challenger” firms are eagerly massing to seize its proposed opportunity. Instead, from the perspective of a smaller firm’s tolerance for Risk or Strategy, images like “Trojan horse” or “poisoned chalice” might have more resonance.
For context, a look at the firms surveyed by the CMA -- measuring by audit revenue, since the CMA would also force the firms to ring-fence their audit practices, via an "operational split" with “separate management, accounts and remuneration,” and also giving effect to the pending merger by which UK firms of Moore Stephens are to join BDO:
PwC Deloitte EY KPMG BDO Grants Mazars RSM
1,334 1,027 677 590 235 157 82 78
Accepting the current impracticality of deploying the smaller firms on the scale of the FTSE 100, the CMA would start with the FTSE 250 – for which, examples of the devilish details lurking in the ambitious remit offered a smaller firm:
- “Undertake a significant part of the overall audit procedure, from both a quantitative and a qualitative point of view,” escalating upwards from 10% over time (¶¶ 4.34-4.35).
- “Regular changes in the allocation of audit procedures between the joint auditors over the years” (¶ 4.34).
- With both auditors having joint liability, “consolidated accounts would be audited by both joint auditors, and then cross-reviewed” (¶ 4.38).
Put mildly, such a program would challenge the challengers. The reasons start with the costs and logistics of choosing to play at all, as confirmed by both this spring’s announcement by Grant Thornton of its withdrawal from the punishing economics of the tendering carousel, and BDO’s modest forswearing of “big table” ambitions.
To achieve joint auditor coverage of the FTSE 250, the necessary ramp-up would likely span the ten-year timetable of the Financial Reporting Council’s re-tendering requirements -- meaning competitive tenders for some 25 new engagements each year. Apportioning success across the smaller firms by their current size would mean perhaps eight new awards each year to BDO/MS and Grant Thornton, and some four apiece for RSM and Mazars.[1]
Not only would this tender process be demanding, disruptive and expensive. But because sole-sourced tender approvals would hardly suit the CMA’s claim for ideologically virtuous competitiveness, multiple submissions for each tender would be expected. The result: a firm’s “win rate” could not be assumed to be more than one out of every two or three attempts.
So challengers would be hit with four separate investment obligations of time, energy and financial and professional resources:
- To obtain and deploy the personnel and expertise needed to understand, scope and submit for competitive tenders in the first place.
- To eat the costs of securing no more than half to one-third of the tenders submitted.
- Actually to staff up and perform a significant body of audit work, for engagements when and as won, that would both increase in complexity and rotate in subject, substance and locations each year.
- And to suffer the flat-out duplication of both cost and hazard involved in two-firm responsibility for the audits of client consolidations.
Finally, after all this effort, would lurk the ultimate threat of litigation exposure -- at amounts that would threaten a firm with bankruptcy and disintegration based on legal fees alone, much less the imposition of serious fines or judgments.
That’s because, under the UK’s liability regime – unlikely to change for lack of either popular support or legislative energy – legal exposure would be “joint and several” for 100% of any auditor failure to satisfy the “expectations gap” – a measure also applicable in the American securities market where significant numbers of the FTSE 250 are present and exposed.
For over a decade I have calculated financial “tipping points” -- liability amounts that would be fatal to an audit firm’s lightly capitalized partnership structure. Those estimates are ominous enough for the Big Four -- at country level, in the $ 1 to $ 3 billion range; for the next tier – observing that the audit revenues of RSM and Mazars are about six percent of leader PwC’s -- their disintegration tolerance level would be on a similar scale.
That a smaller firm can face such a deathblow need only reference the case of Clifton Allen in the US – auditor of the city of Dixon Illinois, and dragged to the precipice before settling its exposure to the notorious Rita Crundwell’s plundering of $ 53 million from the city coffers under the noses of its leaders and its auditors.
To conclude: although gourmands may view foie gras as a delicacy, hardly ever does anyone ask the views of the geese. In sensible decision-making reality, the gorging required for all of the mid-tier firms, to fatten themselves at the CMA’s risky and otiose behest, would be hazardous to their health.
[1] Two related side issues, because the CMA includes no supply-side margin for error. Not even the CMA itself gives credence to meaningful participation by firms at a “third-tier” level, while even a single drop-out based on litigation impact or business risk would reduce the four-firm roster of "challengers" below critical mass.
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