“None of us has a clue.”
The late William McDonough, first chairman of the Public Company Accounting Oversight Board in the US, asked in 2005 what the authorities would do in the event of another global accounting network failure.
My guests posts this week on Francine McKenna’s substack, The Dig (here, here and here) –- posted on this blog here, here, and today -- update this question, first examined in 2006 and periodically refreshed:
What size financial hit could a Big Four accounting network withstand and survive, from litigation damages or an enforcement penalty on the scale of the fatal blow that Enron inflicted on Arthur Andersen in 2002?
Applying a behavioral study done in 2006 to the Big Four’s reported data on global and country-level revenues, that evaluated the willingness of Big Four partners in the UK to sacrifice current income to save a firm from a financially ruinous litigation judgment, the results are ominous:
None of the Big Four accounting networks have the financial resources or organizational stability to survive their largest litigation and law enforcement exposures. If another of the Big Four should fail, the entire model spirals into collapse.
As built out in the first installment, calculations under the 2006 study indicate that litigation-driven tipping points for the Big Four at global level would fall, on optimistic assumptions, well below the level of a firm’s total one-year global profits.
Those limits would however be subject to further erosion based on less optimistic assumptions as to partner behavior, as well as doubts as to the ability of a network to maintain its cohesion and integrity under such challenges, and most especially from a local-country perspective, where the resources to meet a claim measured in the billions (whether dollars, pounds or euros) would be lacking.
Three topics remain to be covered and addressed here –- the basic issue of the structures of the global networks, the myth that insurance would somehow shelter the Big Four from existential threat, and the disruption that would disintegrate the entire model if another large network suffers the fate that befell Andersen.
The Grim Reality of the Calculations
Bearing on the ominous estimates that emerge from the data just summarized are the structural realities of the Big Four, poorly appreciated, if at all: that their make-up as networks of private partnerships operate with razor-thin levels of capital. That is for three reasons:
- Their major working needs -- employee salaries, space costs, and technology and methodology investments -- are financed out of the short-term cash stream of client-derived revenues.
- The income tax codes of the largest economies are cash-based for partnerships, creating a powerful incentive for the firms to distribute substantially all their current profits out to the partners, speedily and timed to match with their immediate personal tax liabilities.
- There being no alternative need to deploy excess capital or outside investment, under the firms’ current business models, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding tanks.
Above all, it must be remembered that the partners of the large firms are not indentured, nor on-call hostages to the assumptions of the politicians and regulators of the world’s large economies. Put under enough stress, they will act to protect their interests.
Financial Resources –- Credit, Liquidity, and Insurance
The Final Paper of the UK’s Competition & Markets Authority (April 18, 2019 (¶ 7.13)) stated optimistically that:
“Deloitte told us it had access to lines of credit from financial institutions to manage working capital, and it had insurance cover to guard against fines and litigation.”
Not so. As shown by the experience of Andersen’s collapse, neither a firm’s working capital nor its insurance are remotely sufficient, measured against the magnitude of a claim on a life-threatening scale.
As for the credit-worthiness of a network under threat, the unraveling of a firm’s partnership structure, as occurred virtually overnight with Andersen and as was foreseeable under the London Economics study, would prompt an immediate shut-down of lines of credit geared to a firm’s loss of on-going viability.
That effect would be dire because, as the financial statements of the UK firms reveal, their readily available resources are limited, for reasons earlier discussed here. As reflected in the UK firms’ latest filings with Companies House (£ billions):
Partner Capital Cash and equivalents
Deloitte £ 256 £ 608
PwC 274 1,128
EY 170 385
KPMG 258 465
All very well, for routine operations in normal times, when the firms’ working capital needs are modest because their businesses run on collection of their client receivables. Instead, a comparison with, say, the 2018 settlement by PwC’s US firm of the FDIC’s $ 635 million award of damages relating to Colonial Bank, for $ 335 million, indicates the liquidity peril that a large enforceable judgment or settlement would entail.
As for insurance, the effective absence of the commercial insurance sector from coverage of the large firms at the current and greatly expanded catastrophic levels, and the limited protection of the Big Four’s own self-insurance by way of loss-shifting to the future generations of their younger partners, are underappreciated factors in this entire calculus.
On the commercial side, to use the colorful off-the-record metaphor of an expert industry source, not only is the Big Four’s patchy insurance blanket far too small to cover the liability bed they have chosen to lie in, but also -- as a consequence of large and growing deductions and retentions -- it is thin, frayed and full of holes.
The reasons are readily available, starting with the misalignment of the Big Four’s large-case litigation profile with the insurance industry’s three required suitability conditions, none of which can the auditors satisfy:
- Diversity of claims –- as is the case in large portfolios such as human lives or auto accidents, but absent in a market of only four participants.
- Predictability of occurrence –- again measurable by actuaries if given a suitably large sample size, but absent for the auditors since catastrophic risks exist with the audit of any public company large enough to house potential misfeasance at the multi-billion-dollar level -– history proving that those will erupt with inevitable frequency despite all attempts to achieve the unattainable goal of “zero defects.”
- Quantifiability of exposures –- also without limit under legal regimes allowing claims for damages on a “joint and several” basis up to the total value of a failed corporate enterprise.
It is not good news that the insurance industry’s readiness over past years to support the accountants has long since been outstripped by twenty years of massive escalation in the size of the “worst” cases. Examples start with the $ 67 billion bankruptcy of Enron itself, followed shortly by the revelation in 2004 of the € 20 billion hole in the balance sheet of Parmalat in Italy -– both ahead of the far larger collapses of the institutions that failed across the globe in the financial crisis that began in 2007, and now extend to such failures as Carillion, NMC, Wirecard and Evergrande.
The cyclicality of the commercial insurance market –- subject to finite limits despite the popular assumption that somehow “insurance is always available” -- now finds greater appetite to cover airline crashes and hurricane damage. For the auditors, even today’s ragged capacity would ill-protect against the chilly horrors of the inevitably recurring new litigation nightmares.
Moving on -- above whatever amount of commercial insurance cover may be available, what self-help is there for the Big Four in the build-up of reserves held by their own “captive” insurance operations?
For a start -- at their global level, access to international network resources by a failing national firm would be hostage to the survivability of the cross-border financial commitments of the network’s other members. Again, that optimistic assumption proved illusory in the speedy collapse of Andersen’s global network in 2002 -- appearances of its members’ ostensibly robust and mutually enforceable contractual commitments notwithstanding.
As one of the authors of Andersen’s uniquely cohesive but ultimately fragile worldwide organization put it, “the structure was at best a treaty. And as a treaty, it was only as stable as the continued trust and commitment of all of the separate country practices.”
And moving further on -- whether captive insurer capacity is measured globally or at the local firm level, as put by the London study (p. 93), “insurance capacity is limited by their (partners’) capital,” such that “captive insurance is simply a timing mechanism that smooths the effect of claim payments…” (emphasis added).
In other words, while “captive” operations may qualify as “insurance” within the scope of the industry’s definitions, they effectively operate only as a means of shifting financial contributions between generations of partners. For purposes of tipping point calculations, if partners were called upon to satisfy a massive litigation claim, their readiness and tolerance to re-finance a firm’s future-looking insurance structure, rather than under-writing payments directly to claimants, would only involve the re-direction of the same amount of their individual financial sacrifice.
That being the case (p. 104), “once the limits provided by the captive have been exhausted, the burden of a large-scale settlement has to be borne by the firm and its partners.” In blunt terms, and as previously discussed, the limiting issue (pp. 104-5) is “the reduction in income that typically partners would be willing to tolerate before jumping ship and endangering the viability of the firm.”
As has been outlined, the readiness of large-firm partners to bear that burden is neither limitless nor satisfactory to assure their firms’ ability to survive.
The Next Collapse: Not Four to Three, But Four to Zero
Finally, loss of another of the Big Four would throw the entire system into chaos — for lack of auditor choice and readiness among the survivors to stay in an unbearably risky business.
As noted in the first installment here, it cannot be assumed that, just because the surviving Big Four were able to absorb Andersen’s clients back in 2002, along with the staff necessary to serve them, a Four-to-Three scenario is also viable today.
In fact, while Andersen’s failure caused a creaking realignment in which all large companies eventually found a successor auditor from within the surviving Big Four, that quartet today is down to its critical minimum. The uneven concentrations of personnel, market share and industry expertise around the world’s largest economies, the politically imposed restrictions on auditor choice due to outmoded concepts of independence, and the post-Andersen fragility of the large networks combine to show that the current tetrapoly structure is irreducible.
Despite Separation, the “Linchpin” Effect
The 2006 London study for EU Commissioner McGreevy was explicit on the broad global consequences of a failure:
“While the demise of a non-key firm may entail some reputational loss for the network as a whole, and potential problems for the firm’s clients in finding a suitable and available replacement audit firm, it will generally not result in a wide-spread disruption across many capital markets.
“In contrast, the demise of a linchpin firm in a network may imperil the whole network and thus have wider repercussions for capital markets in Europe.”
As is now playing out with the Big Four networks separating their member firms in Russia under the international array of Ukraine-based sanctions, a Big Four network can survive the loss of a member firm in one of the world’s smaller economies, where the scale of client operations would allow a network either to replace personnel and resources or to engage a smaller firm to audit a local subsidiary. The challenge would be altogether different if a Big Four network lost its firm in a country of substantial size –- at the level of the G7 economies and perhaps a handful of others -- one of its critical “linchpins,” on which network survival would crucially depend.
The vision should be clear: a Big Four network that loses its member firm in such a country could neither perform the leading and consolidation work for its global-scale clients based there, nor audit client operations in that country to support consolidated reporting by a large company headquartered elsewhere. Local replacement resources would be scarce, unavailable, or unqualified; conflicts and other limitations would disqualify other Big Four firms, whose appetite to take on a single-country subsidiary would be modest; while smaller firms would lack the qualified personnel and industry expertise to serve global-scale enterprises.
Concisely put, the “linchpin effect” involves a darker aspect of the unique dominance of the Big Four of the audit market for large global companies -- if a Big Four network cannot operate everywhere, it cannot operate anywhere.
Further to the Attitude of the Regulators
The CMA’s Final Report proceeded on the blithe and erroneous assumption, that the impact of a Big Four failure would be mitigated by movement of partners and clients and the mobility of audits to other firms, including what it calls the “challengers,” or the enforced continuity of its practice while showing symptoms of failure (¶ 7.7). The reasoning does not provide support:
- The collapse of Andersen, given the difference in current conditions presented by a possible Four-to-Three scenario, remains relevant and is to the contrary.
- Nor is there logic to the CMA’s circular position (Update Paper ¶ 3.137 and Final Paper ¶ 3.176) that the Big Audit model would be resilient against a catastrophic failure because of the regulatory requirement for audits. Imposing a legal obligation does not assure the availability of the means to comply. Official impositions are not self-executing. In a “collapse” environment where supply has become constrained, the existence of an official “requirement” for audits would be no more realistic or achievable than a misguided regulation that all audit reports be signed by a left-handed redhead. Collapse on the supply side would instead only leave the entire system out of compliance –- audits not then being available from any source or at any
The CMA suggests that provisions of some sort would arrest the flight of personnel from a large firm in the process of collapse. Its Final Report (¶ 7.21(d)) contemplated an undefined world in which a regulator would “provide certainty to the markets and transparency to staff to prevent a ‘run’ on a distressed audit practice” (emphasis added).
Experience is to the contrary. The Andersen worldwide structure unraveled at a pace that was neither manageable nor stoppable –- both its management and the authorities were as hapless as all the king’s men and horses confronting the fall of Humpty Dumpty.
Attempted regulatory constraints on personnel mobility would be of doubtful enforceability in any event, while government-subsidized financial inducements could never overcome the looming threat of personal financial ruin that could be inflicted by an Enron-scale disaster.
Conclusion
To recap. The calculations offered here have never been disputed—ominous and shockingly small as they are. No other alternative models or estimates have ever been offered. Nor is there any credible claim that a political or regulatory solution is achievable.
Although a public discussion would be illuminating, Big Four financial fragility has been a “third rail” topic. Little wonder that the only available validation is on deep background — reluctantly given at that — which never rises to a position on the record, but suggests that if anything the cited numbers are too large.
One more down, and they all go down. To survive, the stability of the entire wobbly structure of the Big Four rests on the continuing survival of all of them, including the weakest.
Although this picture is neither cheerful nor optimistic, it should not be taken as the counsel of either cynicism or despair. Grave and pressing as are the challenges to the survivability of the Big Audit model, they are within the grasp of the entire community of interested parties.
Denial and evasion do not, however, comprise a strategy for action. That awaits informed good-faith participation on the part of all players, including a readiness to recognize and accommodate the self-interests of each in service to a process of evolution that can only proceed on holistic and comprehensive terms.
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