I am pleased to offer a two-part guest post on Francine McKenna’s substack, The Dig, to up-date a project I started in 2006, looking closely at the structural and financial limitations on the ability of the Big Four accounting firms to survive their litigation environment. (Part One here, with a Sidebar and Part Two to come shortly.)
"Predictions are difficult. Especially about the future.”
— Attributed to physicist Niels Bohr, or a Danish proverb
What size financial hit could kill a Big Four accounting network -- litigation damages or an enforcement penalty on the scale of the fatal blow that Enron inflicted on Arthur Andersen?
The question is never raised in polite company. The numbers are so small as to be shocking. And the consequences if ever realized would be nearly too grim to bear.
Criticism has been intense of Big Audit, for sure -- the model by which the Big Four deliver assurance on the financial statements of the world’s large public companies. But the threshold issue remains unaddressed. Until it is, no meaningful discussion of possible evolution is possible:
Although scarcely acknowledged across the profession[i], the Big Four do not have the financial resources or organizational stability to survive catastrophe-level litigation or law enforcement exposures. If another of the Big Four should fail, the entire model spirals into collapse.
The reason is that, unlike large public companies with their access to outside investor capital, the privately-owned accounting firms must fund their exposures out of partner profits –- meaning existential threats based on the limits inherent in their organization and business models.
So what is the tipping point –- the size of a financial hit that would be fatal?
After every new revelation of corporate failure or malfeasance, the attitudes of regulators, politicians and the public toward the auditors range from hostility to indifference. But their suggested action list is essentially a blank page. Despite the lack of political or regulatory solutions, the market-place answer matters, and all financial information users should care. Because despite indifference, unease and denial, the loss of another large network would be mean the collapse of the entire Big Audit structure.
I first visited this question in 2006, with up-dates in 2008, 2011, 2015 and 2017, and at length in my book, ”Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books, 2d ed. 2017, pp. 56-64). Over that span the global revenue of the Big Four has grown from some $ 80 billion to approach $ 190 billion in 2022 -– while, as we’ll see, the basic calculations and their implications have not changed.
The unlearned lesson from Andersen’s 2002 collapse is this: in the disruption of the months that followed, all the world’s large companies managed to secure a successor auditor from among the surviving Big Four. But that quartet represents critical mass. There is no serious argument -- under the supply inadequacies of limited and unevenly distributed personnel and expertise, and the regulatory limitations of independence and the narrowed scope of consulting and other ancillary services permissible for audit clients –- that post-collapse auditor replacements would be available. A “Big Three” model is not viable; another collapse would strand significant numbers of the world’s large public companies, leaving them unable to procure the audit opinions required for their securities listings and regulatory compliance, from any source and at any price.
A Model of Behavior, and Its Assumptions
In September 2006, the consulting firm London Economics sent its report to then-EU markets commissioner Charlie McCreevy -– “Study on the Economic Impact of Auditors’ Liability Regimes.” It assessed the threshold of financial pain that would be unsustainable for a Big Four partnership in the United Kingdom, as had happened in the US with Andersen in 2002.
As befit the accounting profession’s long-standing business model –- voluntary private partnerships to which individual accountants commit their energy, reputations and personal capital -- the study was personal. It quantified the limited amount of individual sacrifice beyond which the owner-partners would pursue their personal interests and flee from a business in a death spiral.
Critical numbers of partners would defect, the report concluded, if pushed beyond their individual tolerance -- losing confidence, withdrawing their capital, and voting with their feet. Not forgetting, such self-protective decisions would be taken not in a time of quiet deliberation but -- as those living through Enron will recall all too well -- under the reputational pressure, hostile publicity and litigation exposure of a massively adverse market event.
Exploring the proposition that partners would put caps on their sacrifice of income to defer or mitigate litigation risk, the report questioned the willingness of Big Four partners to forgo important current portions –- pay packets for 2022 topped by the reported achievement of the partners of Deloitte and PwC in the UK at an average above one million pounds:
- What part of that handsome compensation, which make possible their array of appealing benefits –- cottages in the country, club memberships, fees at elite schools, tables at the charity balls –- would they exchange to reduce, but never entirely avoid, a total loss of position and invested capital?
- With professional mobility and alternative prospects available, in other words, how strongly would they price their incentive for current sacrifice?
The London study in effect brought significant real-world financial stake into the “Oreo cookie” experiments originated at Stanford University in the 1970s. There, with multiple later variants, small children were seen in engaging videos, isolated in a toy room, agonizing whether to eat the single cookie on the table, or to wait fifteen minutes for the researcher to return with a promised second cookie.
Whether cookies or partnership shares, human nature under either perspective was not to be denied. As the behavior of the Andersen partners showed in 2002, there are limits to deferrable gratification.
The London study examined a range of scenarios and assumptions, including the length of time over which partners might sustain their sacrifice (three to four years), the percentage of annual profit sacrifice that partners might tolerate (15% to 20%), and the impact of a possible 10% reduction in firm income from a negative reputational effect.
It concluded (p. 105) that critical numbers of partners would bail out, throwing a firm into disintegration, if the alternative was to submit to a financial commitment of individual personal profit reductions extending over three to four years:
“… a sustained income drop in the range of 15% to 20% would result in such a situation. In other words, once the insurance coverage provided by the captive is exhausted, a settlement that would result in such a drop in partners’ income could gravely imperil its survival.”
The Data Underlying the Calculations
Once the London study’s assumptions were laid out, it only remained to run the numbers –- starting with the global environment.
Publicly available financial information for the Big Four provides context. Their latest reported total global revenue -- for 2022 except for KPMG which reports near the end of the calendar year –- is $ 187 billion. Included here, for later discussion, are figures for the UK, the single large country where the firms are obliged to produce and make public their own audited financial statements.
Global Revenue UK Revenue UK Profit
US $ billions £ billions £ millions
Deloitte $ 59.3 £ 4.9 £ 766
PwC 50.3 5.0 1,213
(UK includes Middle East)
EY 45.4 2.75 596
KPMG 32.13 2.43 436
Some assumptions are necessary, as the firms differ in their reporting conventions and timing, particularly as to what the partners are actually taking home:
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- The mature UK market generates roughly ten percent of Big Four total global revenues, so the UK profitability metric is a reasonable proxy by which to extrapolate to the profits of the global networks.
- Second, a choice here is to apply to each network’s global revenue the average Big Four profitability in the UK – roughly 20% -- rather than extrapolating from individual UK firms. The effect is to modestly compress the high and low ends of the ranges, while damping the possible effect of particular local conditions in the UK or elsewhere. Either way, the impact is not significant to the gravity of the indicated results.
Applying the estimated profitability percentage to the firms’ global revenues yields global 2022 profit estimates (rounded US $ billions):
Deloitte - $ 11.9; PwC - $ 10; EY - $ 9.1; KPMG - $ 6.4.
Then using the metrics of the London Economics analysis as applied to the 2022 revenue and estimated profits for the Big Four, estimates can be made of the maximum capacity of a Big Four global network’s partners to absorb and survive a litigation claim at a “break-up” scale.
Once the assumptions are in place, the calculations are a matter of middle-school math. At their most optimistic –- that is, looking for the maximum the partners would give up –- puts the upper limit on their pain tolerance somewhere well below the total amount of a network’s one-year profits.
It’s well not to squeeze these numbers too hard, for at least two reasons.
First, the model’s results vary widely depending on the assumptions. That is, a collective partner willingness to give up 20% of their annual profits for four years would generate a “litigation pot” roughly twice the size if the sacrifice were 15% for three years and applied to profitability reduced under a 10% reputational hit.
Second, as outlined in a Sidebar to follow shortly in a separate post, more refined analysis is hostage to the limited amount and usefulness of the financial information provided to the capital markets by the Big Four themselves.
The punch line of the exercise, rather, is that any confident prognosis for the survivability of Big Audit is not supportable, for reasons that can now be expanded.
The Broad Run-Up in Litigation Exposures
Non-trivial as these calculations might appear, they must be assessed against the scale of recent litigation history.
In the aftermath of the financial crisis of 2007-2008, the large accounting firms successfully resolved huge litigations with modest settlements, all within their financial tolerance. Examples included KPMG resolving Countrywide for $ 24 million and New Century for $ 45 million, Deloitte settling Washington Mutual for $ 18.5 million, and EY settling private investor claims in Lehman Brothers in 2013 for $ 99 million and wrapping up its exposure in 2015 by agreeing to pay an additional $10 million fine to the New York Attorney General.
That said, multibillion-dollar settlements have become all too common, in claims relating to the financial crisis, the sales of mortgage-backed securities and LIBOR and FOREX rate fixing.
Outside the financial services sector, the list of complex mega-settlements includes:
- The total costs for BP arising out of the 2010 Deepwater Horizon oil well catastrophe, approaching $ 65 billion.
- Volkswagen’s settlements, fines, penalties and customer claims payments exceeding $ 24 billion, relating to its diesel emissions “defeat devices.”
- Investor settlements including Enron ($ 7.2 billion), WorldCom ($ 6.2 billion) and Tyco ($ 3.2 billion).
Those company-paid settlements and government fines were only payable, it must be emphasized, because they could be funded out of the investor-supported balance sheets of the publicly-held corporate defendants. By contrast, the Big Four as networks of private accounting partnerships do not have access to the resources of third-party investor capital.
For the Big Four, making the point with clarity are the settlements by Deloitte in October 2013 and PwC in 2016 of their litigations relating to the white-collar criminal enterprise Taylor Bean & Whitaker Mortgage Corp. and its facilitating financial institution, Colonial Bank.
While those confidential and still undisclosed amounts must have included some level of pain, given that the worst-case exposures exceeded their breakup threshold capability, PwC’s experience in finally settling the FDIC’s case against it relating to Colonial Bank is informative.
The FDIC sought recovery for its $ 2.3 billion bail-out cost in one of the largest bank failures of the financial crisis. An extended non-jury trial on liability ended in December 2017 with a blistering opinion by federal district court judge Barbara Rothstein, followed by a second-phase trial on damages that concluded with a July 2018 award against PwC of $ 625 million.
Compounding the uncertainty of appeal from that large but not fatal amount, PwC’s US firm also faced the FDIC’s pursuit of an additional award of interest –- potentially taking a final award to a life-threatening level. Distressing as it would have been, PwC’s agreement in March 2019 to settle all remaining claims and bring the episode to a close with the FDIC for a little more than half the judge’s award -- $ 335 million – enabled PwC to draw a line under an exposure with otherwise firm-killing implications.
Extending the Calculations – From Global to Local
Considering the scale of the huge corporate failures of the last two decades, the global estimates here would be grim enough. But they comprise only a first step, as they are hostage to greater partner resistance or erosion of profitability that would reduce the limit of available funding accordingly.
To emphasize, also, they are worldwide numbers, which assume that a Big Four network under deadly threat could maintain its global integrity and the ongoing support of its member firms around the world.
The contrary should be expected, as illustrated by the disintegration of Andersen’s global structure in 2002. Seeing the rapid flight of Andersen’s non-US member firms, cohesion of todays’ international networks under the strain of death-threat litigation cannot be assumed. Tipping point estimates are required at the level of individual firms in their respective countries.
Two preliminary matters:
- The reticence of the authorities today to face the gravity of another Andersen-scale failure, with consequences that can only be described as dire.
- The mortal nature of the litigation blow that felled Andersen, despite the ostensible but illusory protection afforded by its storied financial success and organizational cohesion.
The Attitude of the Authorities, and the Realities
One of the global profession’s more aggressive critics, the Competition & Markets Authority in the UK, issued a brace of papers after the January 2018 collapse of KPMG-audited Carillion. Its Update Paper of December 18, 2018, glanced with delicacy and understatement at the survivability issue, using rather than “fragility” the language of “resilience” (¶ 3.147):
“We have provisionally concluded that failure of one of the large auditors would be very likely to materially worsen the current choice problems in the market and weaken competition.”
The CMA’s skeptical persistence in minimizing the gravity of the risk (¶ 3.285(d)) was plausibly based on simple denial, resistance, and misplaced reliance on the flawed belief that because there had been no further Big Four collapse, post-Enron, there would not be another in the future.
Facing reality, by comparison, the London Economics study was at least forthright. As examined there (p. 104):
“A mega-scale claim resulting in a large settlement of several hundreds of millions of Euros will be stress on the firm having to settle such a claim.
“At issue, however, is the size of such a settlement that would imperil the existence of a Big-4 network which, in turn, may have significant consequences for the functioning of capital markets.”
Critics of the Big Four have wrung their hands under the mistaken misapprehension that they are “too big to fail” (see the CMA’s Update Paper ¶ 3.149 and the report of April 2, 2019, by the select committee of the department of Business, Energy and Industrial Strategy ¶ 215). They are not. To the contrary, as Andersen’s collapse dramatically demonstrated, the firms with their paper-thin layer of partner capital are not litigation resilient. Faced with potential ten-figure liabilities they are, if anything, too fragile to survive.
Enron and Andersen –- History’s Lesson from 2002
The resistance of the critics and commentators to confront the issue of Big Four fragility is based on the disbelief and denial that there could be another collapse.
The skunk at this garden party –- uninvited, unwelcome and malodorous –- is that a single “bad case” outcome would be as deadly today was the destructive impact on Andersen’s US firm of its exposure to Enron.
That attitude of denial, in turn, is based on the persistently erroneous view that Andersen’s disintegration in 2002 was caused by its Enron-related indictment by the US Justice Department.
In fact, the deadly bullet for Andersen was not its indictment, but its overwhelming litigation exposure. The grave implications for today’s remaining Big Four are illustrated by a partial list of pending claims and exposures of the last half-decade: the claim against KPMG by the Carillion receiver in the UK for £ 1.3 billion; claims for £ 2 billion against EY relating to NMC Health, also in the UK; multiple claims against EY by shareholders of Wirecard in Germany relating to € 1.9 billion of non-existent assets; and the initiation of regulatory proceedings in Hong Kong relating to PwC’s audits of Evergrande, the world’s largest and most over-leveraged real estate development complex.
As the catastrophic impact of “black swan” events makes clear, it only takes a single event -- a Damoclean reality for the viability prospects of the Big Four, which today confront litigation claims that on a “worst case” would far exceed available resources.
Calculations using the London Economics study make plain that the Enron-inflicted litigation blow falling on Andersen was mortal even at the global level. In 2001, its worldwide revenue was $ 9.3 billion. Andersen confronted claims by Enron shareholders in the aftermath of its $ 67 billion bankruptcy, who urged that the case would be the first against accountants to reach a billion dollars in actual recovery.
The crippled firm was already dealing with claims involving Baptist Hospital, Waste Management and Sunbeam, and it was about to receive the incoming bombardment of WorldCom and Qwest, among others. A judgment or settlement at the billion-dollar level would at best have left the firm on the cusp of insolvency, an impermissible condition under the profession’s regulatory schemes that require fiscal viability of a practitioner.
Those who blame Andersen’s death on the Enron indictment miss the point. The firm was like a patient on late-stage life support, already terminally ill and residing in an intensive care unit, who happened to catch a fast-moving infection. Its demise was imminent, and inevitable. By indicting the Andersen firm, the Justice Department only pulled the plug.
Local-Country Separation within the International Networks – A Non-Solution
With its American firm bleeding personnel and clients, and facing ruinous liability exposure over the implosion of its premier Houston client, Andersen’s leaders were unable to negotiate a transaction by which its American practice could be amalgamated in a single transaction with any of the other members of the then Big Five.
The prospect that Andersen’s US practice, as a merger partner or buyout target, might come with the freight of its pending litigation legacy was a burden too great for any of the other firms to take up -- either domestically or globally.
That isolation bears on the issue of the large networks’ current country-based fragility, within their larger international networks. That is, on the one hand, global revenues for all the firms –- broadly publicized by their press offices and on their websites –- are many multiples the size of their country practices alone, suggesting at least superficially that fragility and resilience be measured on a global basis.
Experience, however, was to the contrary. When Andersen’s US firm confronted the mortal wound of its Enron exposure, the speed of flight of the non-US network firms, on nearly an overnight basis, displayed their lack of enthusiasm to provide aide and support to their American colleagues and partners.
Nor would the prospect of support from its foreign brethren for a country firm under deadly litigation threat align with the international networks’ careful and precise descriptions of the separation and independence of their respective country practices. The UK-level financial statements published as required by the large firms do not indicate the existence of any supportive cross-border provisions, undertakings, contingencies or related-party relationships –- any of which would be understandably resisted if serving as fodder for plaintiffs’ lawyers eager to extend their grasp over the full breadth of resources of the firms across the larger networks.
The CMA took a dismissive attitude toward a reprise of Andersen’s rapid collapse. Its Final Report approvingly cited (¶ 7.14 fn. 522) an academic’s view that “the Big Four European or US audit networks would aid any equivalent failure in the UK because of the nature of cross-country subsidiaries and entangled business relationships in today’s complex business world.”
That position lacks credibility. It is doubly undercut, both by the absence of public information as to the extent of the Big Four’s cross-border support commitments or available global-level insurance, and by the directly contrary real-world experience at Andersen, with its speedy demise despite the presence of both.
At the Country Level
As a consequence, tipping point calculations must be made on Big Four results and resources, country-by-country.
Start with the Americas -- the United States being still the world’s most hazardous litigation venue. If left to their own resources, as was Andersen’s firm in the United States, breakup numbers for the US practices of the Big Four today, as calculable under the London study’s assumptions, suggest an optimistic upper limit of range from $ 1.5 to $ 3 billion, ranging rapidly downward under a darker set of assumptions.
Perhaps more dispiriting, applying those metrics to the 2022 revenue and profit figures in the UK, the estimated maximum capacity of a Big Four firm in the UK to survive a single large litigation claim (or multiple claims in the same period) fall in an optimistic upper range between £ 600 and £ 900 million.
To Complete the Picture
Several matters remain to round out the story of the immediate fragility of the large firms: the fundamental challenge of their basic structures, the persistent myth that the availability of insurance somehow shelters the Big Four from existential threat, and the cascade of disruption that would promptly disintegrate the entire model if another large network suffers the fate that befell Arthur Andersen.
These will be taken up in a second installment.
[i] An AICPA/NYSSCPA joint brief in 2010 in two cases before the New York State Court of Appeals — Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP and Kirschner v KPMG, gave passing recognition to the perceived risk:
“The accounting profession is significantly burdened by litigation arising from a widened scope of liability and increasingly aggressive plaintiffs seeking ‘deep pockets’. The biggest threat facing audit firms today is that a single mega-claim or several such civil claims in succession could destroy an audit firm.”