The Big Four accounting firms, under intense pressure in London and with their business model at risk, have at most limited influence. A possible strategy in the face of political and regulatory animosity lies in the folk tale found in many cultures -- the clever rabbit, who evades his dire fate at the hands of the voracious fox by pleading not to be thrown into the briar patch.
It would seem so, watching the televised January 30 session of Parliament’s Business, Energy and Industrial Strategy Committee, on “The Future of Audit.”
The Committee focused on the recommendations in the market study by the Competition & Markets Authority and the review led by Sir John Kingman. While other ideas were tabled, the two headline prospects seem to be: (i) mandatory “joint auditors,” for all but the largest of the FTSE 350 companies, to include the “challengers” – firms below the size of the Big Four – or (ii) compelled reduction of the Big Four’s dominant 97% market share.
Passed over here for possible later attention is the genial shared attitude toward the Kingman recommendations to replace and re-engineer the Financial Reporting Council (see the hearing broadcast at 10.51, 11.04). The track record of the profession’s regulators considered – and images of the crew re-arranging deck chairs on the Titanic are difficult to resist -- supplanting one bureaucratic structure with another appeared not important enough to be worth resisting.
With the Committee’s eager desire to “get on with it” (see 10.59, 11.59), either of these options would have fundamental impact. So it is worth a comparison, from the perspective of the firms both large and smaller.
Witnesses from the Big Four all expressed opposition to a regime of mandatory joint audits, citing:
- The absence of evidence that participation of a second audit firm actually achieves an improvement in audit quality (11.08, 11.29).
- The absence of joint auditor value as shown by the lack of uptake in markets where it is an available but unused option (11.29).
- The record of joint audits in France, the single country where local politics creates particular conditions in the legal and governance regimes (10.50, 11.29), and where it has not opened that market beyond the limited share of a single challenger firm (11.29).
In addition, as a risk issue for Big Four incumbents but also a Trojan Horse for the challengers expected to act jointly, the prospect cannot be avoided of added cost, complexity and performance quality risk (10.46, 11.11). Two reasons:
- First, while the challengers asserted their professional capability to perform, they admitted to significant issues with the expansion to scale of their personnel and expertise capacity (10.01, 10.48).
- Second, under the CMA’s proposal the challengers would not only take on significant basic audit work. They would also conclude and opine separately on an issuer’s top-level financial statement consolidation (see 10.04) – a risk with particular liability implications for audit opinions issued into the litigation-prone Anglo securities markets, the US in particular.
For purposes here and absent satisfactory research either way, the challengers’ position on capability may be taken on faith – although the UK record-setting judgment of £ 21 million awarded on January 31 against Grant Thornton over its audits of Assetco, along with the furor over Grant client Patisserie Valerie’s apparent £ 40 million in falsifications and irregularities, serve the point that audit performance by the challengers is not demonstrably superior to that of the Big Four.
With the steely cynicism expressed by Rachel Reeves as Committee chair, on the expectation of fraud detection in the audit of “a shop that sells tea and cakes” (10.32), the Committee did introduce a new cliché into the never-ending antagonism between auditors and information users.
As noted, and as against the unanimity of Big Four opposition to mandatory joint audits, the large firms’ attitude toward market caps and the surrender of some significant portion of their large-company clients seemed almost benign (11.07-.08, 11.11, 11.28) – for which there are also several reasons:
First, a share reduction from 97% to around 75% might contemplate the shifting of perhaps 60 to 70 engagements over several years time -- each of the Big Four giving up some 15 to 20 jobs.
That’s a modest enough number, especially since the specifics would involve the complex gamesmanship of a four-way dialog among (i) an incumbent Big Four auditor; (ii) the companies identified as candidates, whose audit committees would have to be satisfied with the adequacy of a replacement; (iii) one or more tendering challengers, who would have to demonstrate both the ability to present a satisfactory tender in the first place and execution capability and capacity in the event of success; and (iv) the newly-constituted agency supplanting the current FRC, which itself would be required to ramp up to evaluate and approve the entire process (see 11.09, 11.12).
From the Big Four perspective, the unlikelihood that such a multi-party exercise could be launched and effectively operational within a time span measured in less than a generation would make participation an option with modest risk and more than adequate opportunities to manage to advantage.
All the more, as the Committee seemed to use a metric for selected movement based on head-count (11.07, 11.11), with the consequence that the companies selected for shifting would concentrate at the bottom end of the FTSE 350 scale.
Such a metric might raise an issue of optics and political acceptability, as the companies comprising the bottom quintile of the index by size account for only about 2.5% of its total £ 2.45 trillion in market capitalization. On the other hand, the question is daunting whether the challenger firms could, over any reasonable time span, ever build the capacity or assume the risk profile to take on the company population necessary to represent 20% of the FTSE 350 by capitalization.
To summarize the risk evaluation of a Big Four firm as between the options: A market cap would mean shedding 100% of the liability and exposure involved in the audits of a score or so of smaller-company engagements – with those devolved to challengers willing to accept that start-up issues in the first years of new engagements are well-recognized for maximum risk of failure. Offered a choice, for the Big Four, that risk-mitigating option would seem preferred over the intrusion into their entire portfolios of mandated joint auditors.
Why a challenger firm would want such a supposedly positive opportunity is another matter. Competing each year for the chance to take on an additional half dozen new jobs apiece – all of them larger than anything presently done – with the “early years” challenges and the prospect that any single blow-up on the scale of a Patisserie Valerie could be fatal to their limited financial resources – leadership would need to be bold indeed.
Forced to choose between unattractive options, in short, the Big Four’s strategy to support market caps would adapt from the animal kingdom the rabbit’s view of the briar patch.
Different for the challengers, for whom perhaps better suited is the supposed advice to her daughter by the wife of Prime Minister Stanley Baldwin, on managing a young suitor’s predatory advances. Drawing on her own experience, Lucy Baldwin is quoted:
“Just close your eyes and think of England.”
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