Re:Balance -- Jim Peterson

Audit Reform in the UK? The Queen’s Silence Says It All

As reported in London, there were two notable absences when the Queen’s Speech was delivered on May 10, in the effulgent pomp and circumstance of the State Opening of Parliament.

Missing was the Queen herself, claiming “episodic mobility problems” –- a prudent choice, for a monarch of 96 years and in official harness since her coronation back in 1953.

Second was any mention of legislation on the parlous state of Big Audit –- the model by which assurance is provided on the financial information of large public companies –- a franchise dominated by the tetrapoly of Deloitte, EY, KPMG and PwC.  

The Queen’s substitute was Prince Charles, the longest-serving heir apparent in British history – for which, no criticism. A legislative body with 800 years of history can survive being read to by the senior member of the House of Windsor’s second team.

Less credible is that the energy for audit reform in the UK has run steadily downhill since the January 2018 collapse of the massive contracting and project supervising enterprise Carillion. The immobility of the Boris Johnson government is faced by Kwasi Kwarteng, secretary of the Business, Energy and Industrial Strategy department –- himself frozen in silence on Big Audit since his public mention in January 2021, the first month of his tenure.

The absentee BEIS secretary’s disinterest would be consistent with years of official attitude, in the face of a roster of reports and criticisms: Sir John Kingman’s final report of December 18, 2018, which characterized the UK’s audit regulator --  the Financial Reporting Council -- as ramshackle and shambolic; the Competition & Markets Authority’s Update Paper, finalized on April 28, 2019; the Parliamentary BEIS committee’s report, “The Future of Audit,” of April 2, 2019; and Sir Donald Brydon’s December 2019 report, on his “Independent Review Into the Quality and Effectiveness of Audit.”

With that fulsome body of material in full view, the BEIS department launched its consultation, “Restoring Trust in Audit and Corporate Governance,” in March 2021; with its prompt closure that July, there has been dead silence since.

Political concerns are said to dominate, as the government’s concerns and priorities lie elsewhere. Audit reform is characterized as “boring” by contrast to “wedge issues” designed to “go down well with voters.”

That’s as may be, although it is no less plausible that reality has intruded and that Whitehall may actually realize that its kit is empty of tools.

That is, in the entirety of the proposals floated by the various critics, there are only two with possible direct effect on the business model and performance of the handful of firms that dominate Big Audit.

The first is “operational separation,” by which the Big Four firms have agreed with the FRC to identify distinct leadership, governance, and performance metrics for their audit practices. That insubstantial undertaking was from the start never more than an exercise in optics, as the firms were already running their businesses that way, indeed with considerable public disclosure.

The second was the critics’ notion that both audit quality and large-company auditor selection would somehow benefit if the Big Four were forced to yield up a material portion of their dominant share of the FTSE 350 audit market. The barriers to such a fancied “solution” have been comprehensively laid out, centering on the lack of both appetite and resources on the part of the unfortunately-labelled mid-tier “challenger firms.”

Laid beside the official paralysis, it matters that while evolution in Big Audit is not possible without the participation of all the players -- issuers, auditors, providers of capital, standard setters, regulators and the legal systems and agencies of law enforcement -- each of those has its own vested interest in resisting change, preserving and maintaining a status quo that is viewed as working tolerably well. 

In that context, an observer would be justifiably anxious that any official policy action could deliver unintended consequences all too familiar from earlier efforts –- the hasty passage of the Sarbanes/Oxley law in the US in 2002, the UK’s mandating of auditor re-tender in 2012, and the EU’s parallel imposition of mandatory rotation in 2014.

Not only should the interested parties look to limit official action to the “do no harm” variety, they would well recognize that while the official policy of inaction is in effect, no affirmative harm is being inflicted.

In other words, for those judging the government’s passivity to be fraught, it would be wise to consider the approach of Napoleon Bonaparte in his Austerlitz campaign: “Never interfere with an enemy when he is making a mistake.”

 

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“Managed Shared Audits” in the UK – The Largest “Challengers” Think Not

What – they expected gratitude?

“Managed shared audits” were at the center of the UK government’s March 18 Consultation paper on audit reform. The proposal, aimed to loosen the Big Four’s dominant hold on the audits of the FTSE 350, would specifically benefit the smaller, wretchedly-designated “challenger” firms, by mandatory carve-out of ten to thirty percent of each newly-tendered audit to be gifted to the latter.

For reasons outlined here on April 21, and detailed in my short book on the post-Carillion environment in the UK,[1] the imposition of shared audits across the FTSE 350, never realistic, was fatally flawed and doomed to rejection. Quickly summarized: for the companies themselves, the process would be unmanageable, while the Big Four would gain nothing but valueless inflation of their costs, effort and liability exposure, and the smaller firms could never provide the necessary skills, personnel and capability.

One deservedly skeptical response to this offer –- another version of “We’re from the government, and here to help you” -- is now essentially confirmed. Instead of thankful appreciation, the UK firms of BDO and Grant Thornton – ranked fifth and sixth in the league tables – have recognized and spurned the government’s poisoned chalice. Their “no thanks” -- reported in the Financial Times of May 25 –- was spun diplomatically, as their “considering not pitching for work on shared audits of FTSE 100 companies….”

Their demurrer echoes the mordant humor of Abraham Lincoln, who captured the pain and frustration of the American presidency by likening his position to the man tarred and feathered and carried out of town on a rail – who, asked how he liked it, replied that “if it were not for the honor of the thing, he would much rather walk.”

As put to the FT by Grant Thornton’s head of audit, “If the challenger firm is just going to get what’s left at the bottom of the barrel, that’s not interesting and doesn’t help….”

Although the FT coyly suggests that the two firms “are considering focusing on increasing the number of FTSE 250 companies they audit,” Grant Thornton’s shared audit stand-down aligns with the reasons that underlay its 2018 decision “to stop bidding for audit contracts from Britain’s largest companies after concluding it is too difficult to compete with the Big Four firms that dominate the market.”

Clear perspective on the scale necessary to perform large complex audits reveals these implications, too important to ignore:

• First are the size comparisons illustrated by the 2020 revenues of BDO and Grant Thornton (globally $ 10.3 billion and $ 5.76 billion) –- fractions of the Big Four which range from KPMG at $ 29 billion to Deloitte’s table-topping $ 47.6 billion. The inhibitions on the “challengers” are not (necessarily) those of performance quality. Rather, as one FT reader incisively commented, a house carpenter may be perfectly competent to build a single-family home, but could not possibly qualify to build a high-rise tower.

• Second, in the other direction, BDO and Grant Thornton –- as the largest among the smaller -- were noted by the FT to “earn more UK audit fees in aggregate than the next 14 challengers combined.” Not only should their strategically rational risk and capacity assessments compel a reality check for their brethren down the size chart. In addition, their opting out of a shared audit regime emphatically rebuts the possibility that the remaining firms, however willing, could make up a critical mass of delivery capacity.  

The Consultation’s move for “managed shared audit” took a deliberate pass on even less achievable proposals, to enforce Big Four caps or market share re-distribution of the FTSE 350 audit sector. Its single idea so discredited, whither now?[2]

Fundamental re-engineering of large-company information assurance, guided by the insights of Sir Donald Brydon in his December 2019 “Independent Review Into the Quality and Effectiveness of Audit,” requires attention to the dysfunctionalities embedded in the current model. Those include the archaic and outmoded constraints on the scope of permissible auditor services, and the potentially fatal litigation impact on the firms’ financial and business structures, awaiting with the inevitable financial failures on the magnitude of Enron that disintegrated Arthur Andersen in 2002.

Assurance sufficiently extensive and flexible to be fit for today’s demands will remain beyond reach, until and unless the public dialog embraces discussion of these issues. Otherwise, as BDO and Grant Thornton have now confirmed, the dominance of the Big Four as presently configured –- even inhibited as they are by the golden handcuffs of their franchise -- is the only game in town.    

 

[1] “DOA: Can Big Audit Survive the UK Regulators” (Amazon 2019)

[2] One of the aggressive voices for mandated sector re-structuring was that of the Competition & Markets Authority, then led by since-departed Sir Andrew Tyrie. Even with its bust-up advocacy, the CMA’s April 2019 “Statutory Audit Services Market Study” gave legitimacy to the strategic reluctance of Grant Thornton to pursue FTSE 350 audits, conceding (¶ 3.135) that it “may be a rational reaction….”  

 

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Audit "Reform" in the UK: Hello…Is Anybody There?

Does anybody really know what time it is?

Does anybody really care?

-- The band Chicago’s debut album, 1969

 It’s one thing to discuss the breadth of the UK government’s March 18 consultation paper, “Restoring Trust in Audit and Corporate Governance,” with its 98 questions spread over 232 pages, as I did recently in a conference mixing academics and practitioners.

It’s quite another, and thoroughly dispiriting, to observe the public silence on the likelihood of sustainable change in the model for large-company audits, so roundly criticized since the fall of Carillion back in January 2018 – now more than three years ago.

On the available evidence, the Consultation is being kicked so far into the long grass that it would only be flushed by game drivers and a pack of hounds. One reason for pessimism is the absence of leadership and advocacy.

That’s disappointing, but no surprise. Transformative change always confronts the inertia, indifference, and resistance of those with self-interest in protecting the status quo.

For a list of those missing, start at the top. Kwasi Kwarteng, Boris Johnson’s cabinet secretary for Business, Energy & Industrial Strategy, has spent the last two months at photo ops and shout-outs on behalf of British business -- particularly life sciences, technology and renewable energy – without so much as a mention on his otherwise busy Twitter feed of the Consultation issued under his signature.

The flat-line level of commitment of Kwarteng and his boss at No 10 Downing Street is readable in the silence on audit reform within the legislative program presented by the Queen in her traditional speech on May 11 – an otherwise ambitious list spanning election schedules, national ID cards and NHS funding. That matters, because the Consultation would rely on Parliamentary action to address such major topics as the re-engineering of the audit regulator itself, extension of the duties and accountability of company directors, and the liability regime under which changes to the scope of assurance might be implemented.

Given the complex process in booking law-making time on Parliament's calendar, legislative silence today bespeaks extended future deferral at best, with likely default to indefinite inaction.

Further, while legislation for the replacement of the Financial Reporting Council lies in Parliamentary limbo, Sir Jon Thompson, chief executive of that discredited agency, has avoided taking the bully pulpit of his office to urge an activist role for his agency even under his place-holder leadership on the evolution of large-company reporting and assurance.

That multi-faceted topic, laid out in the perspicacious report offered in December 2019 by Sir Donald Brydon, “Independent Review Into the Quality and Effectiveness of Audit,” with its innovative proposal for the design and recognition of a newly-defined “corporate auditor,” lacks active sponsorship and looks unfortunately destined to gather dust. Sir Donald himself has done valuable and worthy service, but he speaks for no constituency – instead like Oscar Wilde arriving in America to confront its customs authorities, he has “nothing to declare but (his) genius.”

Elsewhere at the agency level, the aggressive position urged by the Competition & Markets Authority, that the dominant position of the Big Four in auditing the FTSE 350 should be forcibly reduced, is left for dead by the Consultation, while the author of that view, then-CMA chairman Andrew Tyrie, was defenestrated in 2020 and has since returned to his political consultancy with a London law firm.

Nor can minority support be expected from the political opposition. Acerbic Labour MP Rachel Reeves, who chaired a BEIS select sub-committee with an aggressive report of its own and who was razor-like in gutting evidence presented by the large firm leaders, has been booted up to the post of Shadow Chancellor.

As for the large firms themselves, sliced and diced at the Reeves committee hearings and on the receiving end of the perpetual scandal-driven question, “where were the auditors?” – it remains the case that ever since the firms locked up their public company assurance franchise with passage of the American securities laws in the early 1930s, the profession has been reactive and defensive in its uneasy relationship with the regulators – an attitude manifest in the UK today in their gentle maneuvering through the process of “operational separation” of their audit and advisory practices.

With all these players retreated to the wings – cometh the hour, cometh the man?

More likely, to adapt the query attributed to Richard Nixon’s secretary of state Henry Kissinger in his sarcastic frustration about talking to Europe – if in search for an effective audit reform advocate, whom should we call?

 

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Audit “Reform” in the UK: Much to be Modest About

“Parturient montes, nascetur ridiculus mus”

 (The mountains labored, and a ridiculous mouse was born)

            -- Horace, 1^st century AD Roman poet

On March 18, the UK government produced its paper, “Restoring Trust in Audit and Corporate Governance” (the Consultation”), eleven chapters and ninety-eight questions, spread over 232 pages plus an additional 300-odd of Impact Assessment and Key Facts and Trends.

Most of its hefty bulk addresses matters of worth, even in respects beneficial, but at two or three removes from actual large-company auditor performance -- the core of public discussion since the failure of Carillion more than three years ago:[1]

• The re-purposing of the UK’s audit regulator.
• The performance and accountability of corporate directors.
• The potential to re-engineer the purpose and scope of corporate information assurance itself.

On these, the right honorable secretary for Business, Energy and Industrial Strategy has borrowed a “conservative” strategy from the medical field. Retreating from or pushing off for later days a lengthy list of more aggressive actions -- none unachievable or likely to have positive effect -- BEIS Secretary Kwasi Kwarteng’s Hippocratic approach is at least likely to “do no harm.”

Although the Consultation introduces itself with chest-thumping self-confidence, aspiring to proceed “quickly” (¶ 1) with “decisive changes” and “significant, targeted measures” (¶ 1.1.2), its substance is almost resolutely modest. In the tones of Wilde’s Lady Bracknell, no manifesto this watery could possibly be accidental – perhaps reflecting both the inevitable push-back from the affected parties, and the limits of the Johnson government’s own available energy.

Space constraints do not permit an exhaustive catalog of the Consultation’s “less is more” approach, but only examples:

Rather than broadly advocating advanced exploration of the “purpose of audit,” as detailed in the December 2019 report of Sir Donald Brydon on his Independent Review Into the Quality and Effectiveness of Audit, and taking on such thorny issues as the interpretation and applicability of established case law (¶ 6.1.16), the Consultation would content itself (¶ 6.1.19) with asking issuers for a “non-binding purpose statement that could evolve over time.”

Rather than endorse and design a properly composed and well-staffed expert forum for detailed lessons-learning from incidents of audit performance deficiencies – “failure study” as well known in other fields such as aviation and medicine – it would timidly establish a “register” (¶ 6.4.10), picking up the high-level suggestion of the Brydon report (¶ 14.3-.4).

A first step this may be, optimistically, although unless designed and authorized to overcome the resistance expected from all quarters, the likely prospect is another mere repository for notifications of non-compliance – a place where opportunities for real learning will go to die.

Rather than examine the reasons why liability limitation agreements have not been used in auditor-client engagements, the Consultation’s abbreviated four-paragraph attention to auditor liability (¶ 6.8) foregoes the opportunity, making only the (concededly useful) suggestion (¶ 6.8.4) that auditor liability in the up-coming expansion into new forms of assurance ought not to be extended beyond that presently in place for statutory audit.

Rather than obliging the large international accounting networks to demonstrate their “resilience” for the benefit of information users, the Consultation would take a tentative and partial step – namely, to charge the anticipated Audit, Regulatory and Governance Authority to seek information from the large UK firms on their financial resources, including their capital and insurance (¶ 8.3.15).

This is in context of the absence of publicly disclosed global financial statements for the large networks, leaving them like the cobbler’s barefoot children, although full-fledged audited statements would be both achievable and informative, as was the several-year experience of the Arthur Andersen global network in the 1970s.

Rather than take up the aggressive critics’ urgings for forced re-structuring of the Big Four dominance of the FTSE 350 audit market – here, credit where clearly due – the Consultation effectively takes the “market cap” notion off the table.

A future review is contemplated (¶ 8.1.14 and ¶¶ 8.1.27-.30), but only after five to nine years of experience (¶ 8.1.26) that would not even commence until regulations had been in effect during the early years of tender and rotation. Thus any such review would not occur until the early part of the 2030s – by which time all current participants will have left the stage, and market and economic conditions will have evolved entirely beyond today’s ability to predict.

Rather than get deeply to grips with the long-running and intractable problem of usable guidance on the prevention and detection of corporate fraud, the Consultation quotes and endorses (¶ 6.4.4) the position in the Brydon report (¶ 14.1.5) that “it is the obligation of an auditor to endeavor to detect material fraud in all reasonable ways.”

Compare. International Standard on Audit 240 states (¶ 5) that the auditor “is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error.”

In the US, the PCAOB’s Audit Standard 1001.02 provides that “the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

None of these three articulations is self-operating as a matter of auditor liability. The significant scrutiny of an auditor’s actual response to indicia of fraud or malfeasance comes in a litigation context, with hindsight allegations of some form of shortcoming. Judges must parse these pronouncements like the medieval theologians debating the number of angels dancing on needle-points. Was an “endeavor (done) in all reasonable ways”? If under the US standard, was “plan and perform” done to a level acceptable in the legal system? Under what standard was the performance “reasonable”?

Information users and practitioners have been dissatisfied for decades. And the language of the Consultation offers no improvement.

Rather than -- to conclude, for now at least, with the subject of internal corporate controls – imposing on UK companies the American requirements under the Sarbanes/Oxley law of 2002, by which controls are signed off by senior executives whose assessments are then attested by the auditors (¶ 2.1.4), the Consultation’s preferred position would leave as optional the question of auditor views on the company’s own assertions (¶ 2.1.41).

Here again, credit where due for restraint. In the 19-year history since the passage of Sarbanes/Oxley, enforcement proceedings and litigation under its provisions on controls have been rare to the point of non-existence. That’s because the Sarbanes/Oxley layering of additional company representations is essentially redundant of the antifraud provisions at the core of the American securities laws, which since the 1930s have made illegal the making of materially misleading statements in the purchase or sale of securities – including in the financial statements required to be signed off by senior corporate executives – making it a doubtful model for the UK’s emulation.  

In sum, over the longer run, the timetable and future prospects for change under the temporizing strategy of Secretary Kwarteng extend down a lengthy road to a dim and misty future.

In the short run, any immediate effect will be akin to that of the little boy in the church pew, suffering loss of bladder control in his dark blue suit: the result is scarcely visible, and does no permanent harm, but it allows the lad to feel relieved and warm all over.    

 

[1] On the two topics that would have direct effect – “operational separation” of the Big Four audit and advisory practices, and the threat to impose “managed shared audits” on the FTSE 350 -- please see my post of April 21.

 

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Audit “Reform” in the UK – the Government Finally Speaks, and Says Little

On March 18, the UK government weighed in with its long-promised consultation paper (the “Consultation), “Restoring Trust in Audit and Corporate Governance.” Ninety-eight questions, spread over 232 pages, contain much that is cautious and little that is innovative. The problem is, what is cautious would not innovate, and what would innovate is not cautious.

For another day, the Consultation’s fulsome treatment of such worthy topics as the re-purposing of the UK’s audit regulator, the performance and accountability of corporate directors, and the very purpose of corporate information assurance. On the central topic of public concern since the failure of Carillion back in January 2018 -- the structure and performance of Big Audit itself -- the Consultation offers on only two items.

These are the “operational separation” of the Big Four’s audit and advisory practices, and the threatened imposition on FTSE 350 companies of “managed shared audits” – a novel concept unknown to either professional standards or actual practice.

The first is easily disposed of, as an insubstantial exercise in optics. The second, to be further discussed, is ill-conceived and deeply flawed.

“Operational separation” should have been recognized as a trifling matter the instant it was mooted (see § 6 of the April 2019 Final Report of the Competition & Markets Authority on its Statutory Audit Market Study).

That’s because the UK critics have neither the will nor the authority to force the Big Four networks to expel either of these core UK components from their global structures – disruptions that would disable them from the breadth of services demanded by the complex auditing of the world’s large public companies. Attempted “full legal separation” at the UK level, in other words, would be either or both legally impossible and globally inconsequential.

Moreover, it’s no surprise that the Big Four would accede to the Financial Reporting Council’s quest for public display of their audit leadership, governance and financial reporting. The simple reason was that they already had such structures and metrics in place -– essential tools for managing these four large businesses -- audit practices having published 2019 revenues of between £ 453 and £ 713 million.

Back to “managed shared audits” -- the Consultation contemplates (¶¶ 8.1.15-.16) that a FTSE 350 client of the Big Four would be obliged in its audit tender process to identify a “meaningful proportion” of its statutory audit -- not less than 10% and desirably closer to 30%, by metrics including audit fees, group revenues, assets and profits – to be performed by one of the so-called “challengers” – that is, a firm below the Big Four in size, yet brave enough to deem itself qualified to propose.    

Whisper who dares: in a triangular relationship among an issuing company, its lead auditor and a “challenger,” such an arrangement could satisfy none of the three.

Because the Consultation would not allow for joint bidding (¶ 8.1.17), a Big Four firm preparing to take the lead would start from an untenable position –- not even knowing the identity of the smaller firm, much less its qualifications, reputation or resources by either industry or geography. Despite which, that lead auditor would, under applicable professional standards and the liability regimes to which its global-level work and overall opinion would be exposed, bear full responsibility for the results of the group audit including the work performed and up-streamed by the “challenger.”

Passing for the moment whether such inhibitions would implicate a scope restriction on the lead auditor’s acceptance and planning (see International Standard on Auditing 300), a lead firm’s risk manager would have cardiac arrest at any lesser level of involvement than essentially 100% re-performance of the work of the “challenger.”

As for the company under audit, its management and audit committee could scarcely with comfort identify between 10% and 30% of its operations to be devolved for audit by a “challenger” whose capability and experience at the FTSE level would range from untested to non-existent.

Complicating the risk assessments of both the company and the lead auditor are two issues that inhere in the globalized nature of the large-company environment. First, a recent study estimates that 62% of the sales of FTSE 100 companies (and 35% for the FTSE 250) are generated in locations and operations outside the UK – beyond the geographic scope of a UK-based audit team. That means either that a “challenger” would be obliged to bring its own global resources to bear at the same level of multi-national scope and scale as its putative client – as the Big Four do now -- or that a company would essentially devolve what it could of its UK-based operations, leaving the lead auditor to carry out the ex-UK work and perform the eventual audit and reporting on the consolidation.

Also on the global front, affecting each leg of the triangle is the FTSE 350’s trading of their securities not just in the UK but in other major markets – especially the US where, as put in a recent cautionary article, American Depository Receipts are offered to investors “for over 200 UK companies including most of the country’s large cap companies.” The long US history of high-cost shareholder and other lawsuits presages liability exposures for which the “challengers” are woefully unequipped, and for which the Big Four would have no appetite to carry the burden of their smaller brethren.

Finally there is the unavoidable but compelling matter of the scale and capability of the “challengers” themselves – who audit none of the FTSE 100 and but ten of the next smaller FTSE 250 (see Figure 38, p. 48, of the Financial Reporting Council’s “Key Facts and Trends in the Accountancy Profession,” October 2020).  

In a 210-page Impact Assessment accompanying the Consultation, a model is cobbled together to support an aggressively optimistic position on the growth potential of the “challengers.” Using historical audit fee income for the five largest, ranging from 1% to 4% (page 127), a “conservative assumption (is made) that annual capacity growth of 2-4% can be safely sustained by challenger firms.”

Two problems – one of method and one of supply – are fatal.

For the first, the model disregards the Big Four-dominated growth of overall FTSE audit fees, as shown by two relevant data points: the 2018-2019 growth in Big Four audit fee income of 6.9% (page 46 of the FRC’s “Key Facts and Trends”) and the UK audit practice growth figures for 2020 reported separately by the Big Four, ranging from 3% to 8.7%.

Bluntly put – at the “challenger” growth rates assumed by the Consultation model, and the faster rates actually achieved by the Big Four -- the “challengers” would be losing market share, not gaining. Not assumed, but indeed omitted, would be the inability of the challengers in this zero-sum environment to grow relatively, enough faster than the Big Four to achieve an actual shift in their market share.

To which must be added a further and final point -- the supply side problem of the “challengers” to grow their necessary rosters of experienced partners. Within the Consultation’s timetable, their only available recruitment sources are the Big Four themselves, where individual partners would understandably question a poacher’s overture: reduced profitability and lower compensation, lesser industry experience and technical support, and uncertain financial resources in the face of expanded liability exposure.

The “managed shared audit” proposal would exacerbate those concerns -- because the partner-level obligations and responsibilities at a lead firm would expand in the execution of an engagement involving a “challenger.”

That is, in a single-firm engagement, a signing partner (and the other partners on a complex job) have the benefit of the coherence, cohesion and efficiency of working with a team of subordinates sharing a common set of methodologies, documentation, vocabulary and communications. Delegations can be made, and expectations set, in the relative confidence of shared membership in a common enterprise.

Not so, where that lead partner would be obliged to receive, review, and accept ultimate responsibility for ten to thirty percent of an engagement as staffed and performed by strangers – for which there could be no solution but to increase dramatically the level of partner time, energy, and attention.

At the broad market level, such a shared-audit concern would anticipate major partner-driven fee increases at the lead firm. At the personal level, Big Four audit partners would expect to see their value enhanced, not diminished, by the forced carving out of portions of their FTSE company portfolios – with a concomitant further reduction in a poacher’s attractiveness.

Shot through as the Consultation is with other failures and short-comings of vision – to be addressed here anon – it is earnestly to be hoped that its proposal of “managed shared audit” will promptly and deservedly be dismissed as impractical and unachievable, lest it crash in unintended consequences if an attempt is actually made to put it in place.

 

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Is Audit Reform Truly a UK Priority? Good Luck With That

Kwasi Kwarteng wasted no time, upon taking office on January 8 as the UK’s new Secretary of State of Business, Energy and Industrial Strategy, in asserting that audit reform was “one of his initial priorities.”

The sounds of earnest innocence might be rather touching, from a government servant, freshly elevated from his Energy remit to become chief minder of the entire sprawling BEIS portfolio. Forbearance for a learning curve may be indicated, as reinforced by a CV that does not reveal experience with the issues afflicting Big Audit.

For the moment, however, and presuming good in Kwarteng’s intentions, queries on his earliest signals are in order. See his first Twitter message, following one of appreciation for his appointment – shouting out a £ 10 million investment to support carbon emissions reduction by the whiskey distillers (@kwasikwarteng), as “something we can all raise a glass to.”

Unfair to compare -- few glasses have ever been raised to salute the auditors, in the centuries since the invention of double-entry bookkeeping. But neither did audit reform rate a mention in the BEIS coverage of Kwarteng’s January 11 telephonic discussion of his priorities with five different British business organizations.

Post-Brexit trade relations with the EU and the state of the COVID vaccine roll-out naturally headed that list, on which audit reform did not appear – these having pre-occupied Kwarteng’s short-lived predecessor in office, Alok Sharma. Which said, the realities underlying the intense criticism of Big Audit in the UK that erupted with the collapse of Carillion in January 2018 now confront the anodyne language of the new Secretary’s introduction.

Government response is awaited to a quartet of reports – Sir John Kingman (December 18, 2018) on the manifold inadequacies of the Financial Reporting Council; the Competition & Markets Authority (April 18, 2019) on the Big Four’s audit market concentration at the FTSE 350 level; the BEIS select committee chaired by MP Rachel Reeves (April 2, 2019); and the extended inquiry by Sir Donald Brydon (December 2019) on the purpose of audit.

While the critics’ array of proposed “solutions” are shelved pending official response, further outbreaks of financial scandal and irregularities, litigation and regulatory impositions have added to the intensity of public interest – both in the UK (e.g., Thomas Cook, NMC Health, Patisserie Valerie, Autonomy) and globally (e.g., Gupta, Steinhoff, Wirecard).

What confronts the prospects and the credibility of Secretary Kwarteng, unhappily, is that he brings to the battle a distinct lack of weapons. As explored in detail in my 2019 book – “DOA: Can Big Audit Survive the UK Regulators?” (Amazon) – there is quite simply nothing in the legislative or regulatory armory that can be deployed to effect fundamental change in Big Audit as presently configured.

In summary:

• Re-engineering of the FRC, decried as “toothless and useless,” into the new Audit, Reporting and Governance Authority, is hostage to necessary legislation, and in any event is aimed not at auditor performance itself but at a regulator whose impact is at best secondary and retrospective.
• Attempts to expand competition with the Big Four, by injecting the so-called “challenger firms” into either joint or shared engagements or by actual forced re-distribution of audit mandates – neither ever justified on the basis of audit quality impact – more importantly confronts the reality of the smaller firms’ limitations in size, resources, geographic scope and risk-taking capacity and tolerance.
  • Auditor changes for troubled companies, in the post-Carillion era, do not indicate optimism that those limitations are subject to relief. The replacement of Grant Thornton by RSM as auditor of Sports Direct (since re-named Frasers Group) in October 2019, after weeks of non-compliance, and the December 2020 replacement by Boohoo of PwC with the much smaller Littlejohn firm of the PKF network, do not signal endorsement that the capacity of the “challengers” is adequate to the task.
• As for the ability of the Big Four to house the ancillary skills necessary to perform audits for the world’s complex companies, in the face of calls that they should be “broken up,” the UK regulators retreated to a process of “operational separation” of the audit practices – not only because full legal separation would have been a reach too far for the UK authorities, but because the negotiated optics-oriented adjustments to the large firms’ branding, governance and internal resource deployment were readily within reach.   

To emphasize – the impotence of Kwarteng and his fellows in the face of Big Audit’s intractable issues does not counsel either cynicism or despair. The world’s capital markets will continue to seek financial information assurance that is both relevant and dependable.

The Brydon report points the way, although not without heavy lifting, as Sir Donald understandably declined to wrestle with several fundamental challenges – notably the audit firms’ presently limited financial and structural stability and the related limitations of archaic rules on independence and permissible scope of practice.

One way or another, those will be solved. Perhaps by another litigation-driven collapse, as with Arthur Andersen in 2002, and replacement of the current model with newly organized and emergent suppliers. Or, desirably but much less likely, by the collective and collaborative efforts of all the relevant players to make the deep and necessary changes.

But not, it must be said, by Secretary Kwarteng. To him, as his day of reality and reckoning awaits, the best and only offer is “good luck.”

 

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The Challengers’ Cup – An Auditor’s Poisoned Chalice?

Two events in the last week of October are related:

On October 25 the Financial Reporting Council, the UK’s audit regulator, released its latest “Key Facts and Trends in the Accountancy Profession.” The headline was that the Big Four had increased their market share, auditing 100% of the FTSE 100 and building their audit fee income by 1.7%, while the smaller firms doing public interest entity audits saw theirs reduced by 6.7%.

Also, high street sportswear retailer Sports Direct, owned 60% by its bumptious chief executive Mike Ashley, reported on October 23 its success after six weeks of default in replacing auditor Grant Thornton, which had resigned just before the company’s annual meeting. Although Ashley had previously insisted that only a Big Four firm would do (July 26 release of preliminary yearly results, p. 11), the willing firm was RSM – seventh by size in the UK as measured by audit fee income.[1]

For context, important developments are pending in the highly charged UK environment:

• The delivery of Sir Donald Brydon’s fulsome project on “the effectiveness and quality of audit,” expected mid-January according to his Twitter feed (@BrydonDonald).
• The uncertainty under a Brexit effect of legislation to implement the recommendations of Sir John Kingman to supplant what he called the “ramshackle” FRC with a new Audit, Reporting and Governance Authority.
• And the prospects for action on the advocacy of the Competition & Markets Authority and the BEIS committee headed by Labour MP Rachel Reeves for joint audits of the FTSE 350 with mandatory challenger participation, or other forms of coerced audit market reduction of the Big Four’s dominant share.

Years of experience and hindsight will likely be needed, to determine whether RSM’s undertaking of an engagement shunned by all of the Big Four and other challengers will prove either very brave or very foolish.

On that, the constant business press visibility of Mike Ashley’s swashbuckling adventures suggests that RSM’s risk managers must be devoting sleepless nights to the acute recognition of the hazards of their mission – considering that, as put in the firm’s 2019 Transparency Report (p. 41) “in general (the firm) is not active in high audit risk environments.”

Perfectly understandable -- because any proceedings by investors or law enforcement arising out of Sports Direct’s accounting and public reporting would likely have a one-and-done impact on RSM’s very stability. Its audited 2018 financial information, the latest available, includes only £ 13,000 in “provisions,” none identified as litigation; it references only unspecified but “appropriate professional liability insurance;” and it indicates no financial commitment or support from the RSM network’s global structure – confirming, as put in the same Transparency Report, that the each firm in the RSM international network is “a separate and independent legal entity” and that “no single member is responsible for the services or actions of another.”

The relative size of the Sports Direct engagement matters. It is to be RSM’s only FTSE 350 engagement. With a market cap of £ 1.7 billion, it is multiples the size of RSM’s handful of AIM-listed companies. And for an extra risk factor, the company’s NASDAQ listing of its ADRs (SDISY) brings the attendant challenges of compliance with the American securities and auditor regulation regimes and exposure to the hazards of US litigation.

Returning to the broader audit market share issues – the extent of business media attention to the single event of RSM’s hiring should be a check on the CMA’s advocacy that challenger firms should take on 20% or more of the FTSE 350 work over something like a ten-year span.

That is, the CMA’s proposal would mean the migration to new auditors of some 70 companies or the equivalent in joint audit participation. If allocated to the challengers according to their 2018 audit revenues[2] -- having added one, RSM would be looking at nine more; Crowe and Mazars as the two smallest might take up ten between themselves; BDO and Grant Thornton as the two largest would look to add a couple dozen apiece.

Yet to date, neither the politicians, the regulators nor the strident critics of the profession have advanced anything like strategic plans by which those firms would succeed in developing or delivering the personnel, expertise, geographic coverage, financial resources or risk appetite upon which to scale up from RSM’s one-off.

Should Mike Ashley have been left to stew in the consequences of his own attitude? The authority of the UK business secretary to appoint an auditor only addresses a board’s failure to act, not an enforced appointment in the absence of a willing candidate – nor would an attempt at governmental conscription align with the profession’s requirements to rely upon and have a mutually trusting relationship with a client.

Put another way, and by no means impugning either the ambitions of RSM and its challenger brethren or the enthusiasm of the critics, reality intrudes. However enthusiastically a “Nirvana fallacy” may be urged, the frequency of its repetition neither adds legitimacy nor rebuts the folly of unachievability.

 

 [1] As a parenthetical, for those interested in the vexing question whether the investing public actually does value the audit function: Sports Direct’s share price on the LSE actually rose by five pence both on July 29, the day Grant Thornton announced its resignation, and September 11, the day of the annual meeting when it was conceded that no successor was engaged, and then fell by six pence on the day RSM was announced.

[2] Updating from the prior year’s figures in my recent book, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon May 2019).

 

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What’s Hot in Big Audit? October 4th at the ICAEW in London

A major up-dating is set for October 4 at the London home of the Institute of Chartered Accountants in England and Wales – its 2019 Audit Conference, “Reflect, Reform, Refocus.” Proceedings will be reported in the next issue of its magazine Audit & Beyond – but live attendance on Friday will be worth it.

The context is volatile and challenging. Relevant current events include:

• The September 23 collapse of venerable travel operator Thomas Cook, this time with a gloss on the expected query -- “Where was EY?” -- that features the absence of a “going concern” qualification in its 2017 and 2018 opinions.
• The on-going noncompliance of Mike Ashley’s Sports Direct with the requirement, unfulfilled since its September 8 Annual General Meeting, that the company find an auditor willing to succeed Grant Thornton.
• And the persistent silence of the Competition & Markets Authority, following its April 18 report, which proposed that most of the FTSE 350 should be obliged to engage a second audit firm, selected from among the so-called “challengers.”

These items of immediate attention are piled on those of recent months, in addition to the CMA’s report – the report by Sir John Kingman on December 18, 2018, which set up the on-going process of rehabilitating the Financial Reporting Council into a new Audit, Reporting and Governance Authority, and the April 2, 2019, report of the Business, Energy and Industrial Strategy committee of Parliament with its calls for yet more aggressive steps to force a reduction in the near-total large company audit dominance of the Big Four, break up the Big Four, or hobble the scope and skills of their audit practices.

The morning keynote speaker at the ICAEW conference will be Sir Donald Brydon, expected to bring the world up-to-date – albeit with sensitivity and due regard for protocols and discretion – on the state of his mission, launched in December 2018 by the Business Secretary, to inquire and report on “the Quality and Effectiveness of Audit.”

Views on the broad range of concerns will be offered by speakers from practitioners, the standard-setters, and the regulators – see its programme.

I will be there, with a few words to offer. No spoiler alerts are needed – the grounds and reasons for my skepticism about the mooted “reforms” are laid out in my book of this May, short but detailed -- “DOA: Can Big Audit Survive the UK Regulators?”

For those unable to be in Chartered Accountants’ Hall on the 4^th, my perspectives on the issues derive in good part from this single graphic, showing the global accounting networks with 2018 revenue greater than $ 500 million.

Anyone paying attention to the implications of this array, and still clinging to the belief that either joint audits or forced market share re-allocation can be achieved, is invited to bring forth the arguments. Presentation space will be offered here, free and in full – fairly warned that the section will be labeled “Fiction and Fantasy.”

 

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Sports Direct’s Audit – Anyone Up For A Challenge?

If I were teaching my graduate course in Risk Management and Decision Making this summer, its final exam would pose the questions in this real-world dilemma, confronting senior management of the United Kingdom’s mid-sized accounting firms -- dubbed by the Competition & Management Authority the “challengers”:

High street retailer Sports Direct, mightily fallen from its brief stint as a FTSE large company but still listed and public, lacks a successor for long-time auditor Grant Thornton, which announced on July 29 that it would not stand for re-appointment.

The company’s CEO and largest shareholder, swash-buckling Mike Ashley, had postured, as its results were released on July 26: “we do not believe a firm outside of the Big 4 will potentially be able to cope with such an audit in the future.” Spurning Ashley’s come-hither attitude, each of those firms has explicitly demurred -- as has BDO, largest of the challengers.

First question: is another challenger willing to propose, or not? For a firm eager to push its way up the rankings, it could be a golden opportunity. Or else, the definition of a poisoned chalice, with risks and hazards of an engagement as large or larger than any in its existing client book.

Which way the reputational effect? For better or worse the company’s governance is under fire, derided as “out of control” and “a total and utter shambles;” it faces such side complexities as the delayed accounts of Ashley’s personal holdings in Sports Direct and football club Newcastle United; its stock price has tumbled below 240p, from its 2014 peak of 922p, and is now below its 2007 listing price. Its issues will be highly visible in the already-inflamed Big Audit environment.

As for the economics? Grant Thornton’s audit fee for 2017, reported in the latest Accountancy Daily survey, was £ 1.4 million-- for an estimated profit on the order of £ 200-250 thousand. A projection from that figure would be hostage, however, to the doubtful assumption of no further developments. That is, the cost to address even a modest extension of necessary extra audit work, or a lawsuit or investigative inquiry – legal fees and diverted management time alone – would swamp any engagement profit within weeks.

And that’s without thinking of the potential fines or judgments. Could the revenue justify that risk? No fee can be set and charged that would protect an auditor in the fraught context of Sports Direct -- simply impossible. On the large-company scale, Arthur Andersen disintegrated in 2002 under litigation exposure to Enron’s $ 67 billion bankruptcy; in March 2019, PwC settled its judgment of $ 625 million relating to Colonial Bank by agreeing to pay out $ 335 million.

Even much smaller companies can inflict deeply painful consequences. Grant Thornton itself is experiencing its 2019 judgment of £ 21 million plus court costs of £ 5 million related to Assetco, and has pending its day of financial reckoning arising from the indicated falsifications estimated at £ 94 million and shareholder losses of £ 446 million at Patisserie Valerie.

Further, a challenger firm’s liability insurance deductible alone would exceed its annual profit from Sports Direct, while the modest ceiling on its insurance cover would trivialize that “protection” in the face of investor and enterprise losses if Sports Direct continues on its stumbling path.

Worst case, as applied to the 2018 revenues of between £ 500 and 160 million, for the next five UK firms smaller than opt-out BDO, the behavioral model for an accounting firm’s maximum survivable litigation hit, done for the EU commissioner for markets in 2006[1] -- a blow that would fatally de-stabilize and break up a firm would range from about £ 100 million down to perhaps £ 35 million – well under the threat levels lurking at Sports Direct.

Could a firm be arm-twisted by the authorities? The ability of a professional to exercise judgment in client evaluation and acceptance would be hostage to such unseemly over-reach – as would the integrity of the firm leaders’ professed commitments to improve their quality of performance and satisfaction of user expectations.

Meanwhile, the UK regulators are in no position to use force. Not only is it inapposite to consider the suggested but untested authority under Section 490 of the Companies Act 2006 to appoint an auditor if a company fails to act. Any official attempt to press-gang a reluctant firm into an unwanted audit engagement would further the diminishment of the profession’s stature and legitimacy that goes back to the inflictions of Sarbanes/Oxley in 2002.

This, then:

• The adverse consequences of mandatory auditor replacement and constraints on the scope of permissible auditor services are manifest.
• Equally apparent is the insufficiency of long-argued but unachievable “solutions.”
• Regulators and politicians are effectively helpless to impose non-consensual audit assignments.

Under these unhappy conditions, barnyard metaphors are irresistible:

• The chickens have come home to roost.
• The foxes have invaded the henhouse.
• And the capons are squawking around with their heads lopped off.

Students undertaking this examination are reminded that their analysis and answers to these questions are due before the company’s September 11 annual general meeting.

[1] Discussed in detail in my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (2d ed. 2017) at pp. 45 et seq., and a central theme of my recent book on the volatile state of the UK environment, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon May 2019).

 

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A Taxman Cometh – The United Kingdom Gets a New Audit Regulator

London continues the center of political and regulatory threats to the Big Audit model – there being no way to tell the difference between Washington’s summer torpor and the chronic somnolence at the SEC and the PCAOB:

 “Cometh the hour, cometh the man”? Perhaps – although not clear.

Whitehall’s July 18 announcement is that career civil servant Sir Jonathan Michael Thompson – “Jon” yclept – will leave his post as chief executive of HM Revenue and Customs, succeeding Steven Haddrill, the lame-duck chief executive of the Financial Reporting Council.

He will arrive in interesting times. The FRC – “toothless and passive” as described by Labour MP Rachel Reeves, and in City grandee Sir John Kingman’s December 18, 2018, report (¶ 4) “a rather ramshackle house … built on weak foundations” – is to mutate into a newly configured Audit Reporting and Governance Authority.

Or not. Housekeeping adjustments at the FRC began with uptake of the Kingman report by Greg Clarke, cabinet secretary for Business, Energy and Industrial Strategy. More serious changes require legislation, although whether any law-making energy survives the Keystone Kops environment of Brexit will abide – as will, indeed, any policy initiatives that may outlive the dubious tenure of a Tory government predicted to be led by Boris Johnson.

To fulfill ARGA’s charge, described in the July 18 Financial Times as “restoring confidence in the quality of the audit work in the UK after scandals at companies such as Carillion, the outsourcing group,” Thompson steps into fraught conditions.

First, as addressed in detail in my new book – “DOA: Can Big Audit Survive the UK Regulators?” – he will find his regulatory cookbook lacking achievable recipes:

• The headline recommendation in the April report of the Competition and Markets Authority was that all but the largest of the FTSE 350 companies should engage two audit firms. The problem is that if enacted, a requirement that second auditors be selected from the ranks of the “challengers” would suffer irredeemable impracticality based on those firms’ limited scale, capacity, financial resources and risk tolerance.
• The CMA’s other proposals -- that there be “organizational separation” of the Big Four’s audit practices, and that they should foreswear all ancillary services to audit clients -- were already either fait accompli or well capable of adoption, yet are of dubious and unproven impact on the quality of auditor performance.

Second, the more aggressive actions urged by press and academic critics as well as the April 2019 report of the Reeves committee -- such as enforced reduction of the Big Four’s market dominance, actual break-up, or shrinkage of the large firms to “audit only” -- have failed to acquire traction.

Third, presuming the best of regulatory intentions at the new ARGA, reality will intrude to impose practical limits on the scope of any enforcement penalties -- the head-on hazard that the failure of another Big Four firm, in a reprise of the 2002 litigation-driven collapse of Arthur Andersen, would disintegrate the entire model.

Last and most important, ARGA will inherit two of the FRC’s structural handicaps – that by the nature of its auditor oversight remit it is distant by two removes from the machinations of corporate malefactors; and that, like any enforcer, it will be under-resourced, politically stressed, and consistently late to arrive on the scene of the next and inevitable outbreak of scandal.    

In this less-than-optimistic setting, Sir Jon brings to his new task a CV in government accounting and finance and a career-long string of civil service postings – none relating to the profession of public accounting or, in particular, the national and global complexities of the Big Four networks’ provision of audits for the world’s large public companies.

Rather, as the FT observed, his tenure at HMRC included “controversy over staff bullying” and “an independent review (that) found that abrasive behavior was prevalent.”

Context affects the prospects for success. “Horses for courses,” as the English put it. Or in the tactics manual of the American mob, “don’t bring a knife to a gun fight.”

Is a bare-knuckled bureaucrat well suited to the UK’s multi-party bun-fight over its audit model? Critical public reaction to the evidence given in last January’s committee hearings by non-auditor representatives of the large accounting firms suggests the importance for credibility’s sake of detailed experience and communication capability.

Credit Sir Jon with the energy and skill set of an experienced civil servant –- whether or not transferable to a radically different context, where both enthusiasm and ideology may well be sucked into the vortex of Big Audit’s technical, professional and business structure and culture – enough to smother the best of intentions.

One risk is clear: his initiatives will be hostage to the Dunning-Kruger effect – the prospect that inexperienced decision-makers will suffer all-too-human over-confidence and fail to recognize the limits of their capabilities in a complex field.

As the current occupant of the White House in Washington has been fond of saying since 2016, about his own ad lib initiatives that so often dissolve into thin air or inaction, “We’ll see.”

 

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My New Book -- "DOA: Can Big Audit Survive the UK Regulators?"

It is a pleasure to announce the availability of my new book -- "DOA: Can Big Audit Survive the UK Regulators?" -- now available in paperback and e-reader versions through Amazon -- here. 

To summarize the story, which is little enough comprehended even in the United Kingdom, and both seriously under-reported and much misunderstood in the United States and elsewhere:

"The collapse of Arthur Andersen in 2002 reduced the large accounting networks to the Big Four – Deloitte, EY, KPMG and PwC. Can they survive, in a model fit for purpose?

 "Public criticism and the hostility of regulators and politicians are intense, especially in the United Kingdom since the January 2018 collapse of contracting giant Carillion. The debate is joined, the outcome is uncertain, and the consequences to the capital markets will be profoundly disturbing.

"The issues are complex: audit quality, the 'expectations gap,' competition and choice. Disruptive 'solutions' include breaking up the Big Four, stripping their people and services back to 'audit only,' and even nationalizing audit assignments. 

"DOA surveys the background to the current UK environment, examines the possible actions, and assesses the doubtful prospects for beneficial change." 

By its focus, in the current volatile British environment, on the political, regulatory and litigation risks that swirl globally around the Big Four, DOA is a sequel to the detailed scrutiny of these issues in my earlier and still-relevant book, "Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms" (Emerald Books, 1st ed. 2015, revised and extended paperback edition 2017 -- also on Amazon).  

The certainty of global implications for the continuing availability of assurance on the financial information of the world's large public companies, including the stability and viability of the Big Four themselves, makes broadly relevant the actions and decisions of the regulators and politicians in the UK. 

I invite your attention to the examination in DOA of these important issues. Please share with friends and colleagues. Comments here via the Main page, and reactions and suggestions to me at [email protected], are invited and most welcome.

 

Facing the British Politicians – A Strategy for the Big Four

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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Serious Changes in Big Audit? Not From The UK’s Labour Party

As London debates over the future of Big Audit, there is a minor diversion from the hefty tomes released on December 18 by the Competition & Markets Authority and the committee charged by Parliament and headed by Sir John Kingman.

Their proposals will elicit levels of sound and fury: the Kingman committee would trash the Financial Reporting Council and re-build the country’s audit regulation, and the CMA’s two-fer would inflict organizational separation on the audit practices of the large firms, and oblige FTSE 350 companies to endure “joint audits” with the participation of non-Big Four firms.

Further attention is promised, under the government-sponsored “Project Flora,” to be headed by London Stock Exchange chairman Donald Brydon, and by the Parliament’s Business, Energy and Industrial Strategy Committee, whose first session is scheduled for January 15.

So take passing note that on December 13 the Labour party’s shadow chancellor John McDonnell brought forth his own report – 170 pages of perfervid criticism of the history and performance of the Big Four firms. More qualified scholars will assess its legitimacy as research, while from a real-market perspective, and drained of its hyperbolic antagonism, the extended screed reduces to a menu of proposals of eye-watering impracticality.

While it appears accepted by all parties that dependable assurance on the financial statements of the world’s large companies continues to be valued by the capital markets, here are only two illustrations of the report’s departure from that context’s reality:

• “Big Four firm share of the audits of FTSE 350 companies must be capped at 50% of that market” (p. 91).
• “A new statutory body, equivalent to the National Audit Office (would) conduct real-time audits of banks, building societies, credit unions, insurers and major investment firms” (p. 70).

Neither position found favor in the CMA or Kingman reports. But the prospect of political up-take makes it useful to explore briefly the fatally flawed nature of each.

First, reduction of the Big Four’s dominant 97% market share of FTSE 350 audits would crash headlong into a stark reality: although misguided regulators have the power to legislate some sort of “market cap,” they have no answer to the question, “who would actually do the work?”

Various metrics make the same point, starting with a graphic and league table published here on September 25 and November 12 that illustrate the overwhelming scale issue: the demands of a large-company audit are simply beyond the smaller firms’ capacity in personnel, industry expertise, global presence and risk tolerance.

Looked at a different way -- the measure of materiality agreed by KPMG for Barclay’s 2017 audit was £ 225 million – compared with the latest audit practice revenues of the six UK firms below the Big Four, set out in the Labour report itself (p.22) as ranging from £ 155 million down to £ 27 million.

The two largest erstwhile candidates to supplant the Big Four have agreed. Grant Thornton, fifth-ranked by size in the UK before giving effect to the BDO/Moore Stephens merger, has foresworn competing for FTSE 350 audits. And as put by BDO UK’s chief on December 14, “BDO was not looking to make itself grow to the scale of the Big Four …’.”

As put more bluntly in the CMA submission of Serco PLC:

“The mid-tier firms do not possess the capability nor experience to undertake complex, international audits.… There is an important role for mid-tier firms to play but it is not the audit of complex, international companies.”

Nor do they have an alternative supply of talent, as poaching in volume from the Big Four will not happen. The collapse of Arthur Andersen in 2002 taught that restive senior personnel have alternatives to remaining on the bull’s-eye of private practice, from which they fled in large numbers. And in any event, critics could scarcely welcome a market re-shaped by migration of alumni from the Big Four whose performance they so roundly excoriate, only to re-emerge in the smaller firms.

As for a newly authorized version of the National Audit Office (here, for short, “NNOA”) to audit the country’s financial sector, there is a glaring list of disabilities – here to note only three:

First, referring back to previously-cited Barclays Bank, some two-thirds of its revenue is derived internationally. An NNAO would be obliged to rely on Big Four firms for help outside the UK, there being no alternate sources – non-UK firms unwilling to be subordinated to a foreign bureaucracy for politicized supervision and liability.

At the same time, while the Labour report criticizes the Big Four’s supervision and control of their international networks (see p. 64), a NNAO itself would be no more able to spot or prevent a remote rogue trader, the likes of Nick Leeson in the Singapore office of Barings.

Second, what of the UK operations of financial institutions headquartered elsewhere? Of the world’s twenty largest investment banks, only Barclays and HSBC are based in the UK, where they compete with such formidable multi-nationals as JPMorgan Chase, Goldman Sachs, Citgroup, Credit Suisse and Deutsche Bank.

Given their percentage of the UK sector, the mission of a credible NNOA would be undercut by leaving those audits status quo in the hands of the Big Four. But if it did attempt to audit their UK operations, could it expect its work to be accepted globally by the banks themselves, their ex-UK auditors from the Big Four, their own principal regulators, or globally-oriented investors?

Third, in any event, the UK banks are subject to extensive ex-UK oversight and regulation. For example, Barclays and HSBC with their securities listed in the US must be audit-compliant with the rules of both the SEC and the PCAOB.

That means that an NNAO would have to register and submit itself to the inspection process of the PCAOB. Its performance would be subject to liability under the American securities laws, on a “joint and several” basis for any performance shortcoming, and with no SEC-permissible cap or limitation.

It is for the political scientists to reconcile these real-world exposures with Labour’s antipathy toward foreign entanglements and diminished British sovereignty, as on display in the Brexit debates. But with the billions in fines paid by non-US banks growing out of the financial crises of 2007-2008, and the current overhang of the FDIC’s judgment for $ 635 million against PwC over its audits of Colonial Bank, a British civil servant would be brave indeed to serve as signing partner for an NNAO audit of a UK-based bank.  

 

Further detail would only be-labour these issues or the many others in the shadow government’s report, when there are more pressing concerns. For now, thanks for joining this discussion. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.

 

 

 

Joint Audits for Large Companies? The UK Might Wish It So

“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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“Audit Only” Big Four: The UK Officials Bring Coal for Christmas

Like turkeys anticipating Christmas dinner, leaders of the Big Four in the UK await the preliminary findings promised by the Competition & Markets Authority’s Andrew Tyrie and the committee charged by Parliament and led by City grandee Sir John Kingman.

That’s because a much-mooted “solution” to widely-perceived issues of audit quality and competition would require forcible reduction of the firms to “audit only” – that is, stripped of the ancillary services formidably built in the last twenty years.

To see the scale involved – since the late 1990s when all the large firms but Deloitte hived off their consulting practices, the surviving Big Four in the UK have ramped up non-audit services – under such various labels as Advisory, Consulting, Financial Services, Deals, and Tax Pensions & Legal – so that traditional audit and assurance now account for only between 35% (PwC) and 25% (KPMG) of their 2018 revenues.

Further official attention is assured, with the November 12 pronouncement of Rachael Reeves, chair of Parliament’s Business, Energy and Industrial Strategy Committee, that “the audit market is broken … and all options are on the table, including measures to break the stranglehold of the Big Four.”

Conspicuously lacking in the advocacy of radical surgery is reasoned attention to the impacted delivery ability of the large auditors. Two key issues bear on the needs of the UK’s largest companies:

First, audits require many diverse specialist skills, as recognized in the professional standards -- see International Standards on Auditing (“IAS”) 220, PCAOB AS 1201 -- many identified in, e.g., PCAOB AS 1210. Examples were surveyed in Deloitte’s submission to the CMA of October 30, 2018:

“On complex audits we regularly use specialists from across corporate tax, transfer pricing, actuarial, IT and cyber risk advisory, data analytics, valuations and financial instruments together with industry specialists to identify risks and challenge management.”

Non-audit specialists must satisfy criteria on their qualifications, including avoidance of conflicting interests. If housed inside an audit network itself, those requirements are manageable with the imposition of its independence requirements. If hired outside, however, while rules as to conflicting interests still apply (see ISA 620.9, AS 1210.10-.11), no such monitoring infrastructure is required.

So a daunting supply issue is that a provider of expert services such as actuarial, appraisal, petroleum engineering or artificial intelligence would have no incentive to restrict itself from working directly with a large global company, against the uncertain hypothetical possibility that at some unspecified time in the future, it might be asked to support the work of that company’s then statutory auditor.

Ancillary services inside a Big Four firm can sustain themselves, grow and prosper through work for companies that are not audit clients, then being available to support its audits.

But that would not be possible for an audit-only firm, as it would be unable to recruit, train and retain the necessary roster of non-audit skills if only on-call for the limited amount of work needed as audit support. As Deloitte’s CMA submission put it:

“The multi-disciplinary model also provides the best opportunity to attract the highest quality talent and provide for their rounded development. It provides the scale, financial resources and skills needed to innovate and invest in artificial intelligence and technology to continually improve quality and evolve the audit product to meet the needs of 21^st century stakeholders.”

Second, to the impact of audit-only on the firms’ global network structures, an audit-only UK firm will necessarily require extensive foreign support, and lots of it. With some 70% of the revenue of FTSE 100 companies derived ex-UK, audits relating to that massive activity must be done outside the reach of the jurisdiction of the UK regulators.[1]

If a UK audit-only firm were forced out of a global network, its ability to engage foreign support would founder on the unavailability of firms from other networks to assist, as many if not most will have disqualifying engagements to provide non-audit services available within their structures.

Perhaps, however, if it were obliged to establish distance from its non-audit brethren, there would be no necessary reason (other than cosmetic) why that newly-orphaned firm could not remain within its international network.

That’s because, as set forth on their websites, the large networks are aggregations of clearly separate legal entities, for reasons of local licensing and regulation. The Big Four networks essentially comprise sheaves of contractual agreements, with numerous examples of member firms doing no audits at all.[2]

Payments of fees for shared methodologies, training, support and licensing would then vary only as a matter of degree and continuity of relationships, across a spectrum from one-off payments for single engagements to full-time or long-standing, preferred-provider obligations.

As a historical note, prior to its collapse in 2002 the Arthur Andersen worldwide organization was in its lifetime the only network whose global partners had truly shared common financial interests in the entire global operation.

Might a newly spun-off firm in the UK, providing ancillary non-audit services, choose and be able to stay inside its old network? Maybe yes, maybe no.

If yes, and a stripped-down audit firm kept working with the network and its newly re-organized co-member, little save literal compliance would have been accomplished, and the optics might likely not satisfy the critics. If no, however, could a newly-isolated non-audit firm be hired by the audit-only firm? Again if so, the effect would be limited, and the cosmetics issues would remain.

How the UK regulators and politicians may manage to stumble through the maze of these confounding questions will make for interesting watching – as we otherwise pause for the holidays and contemplate the approach of a challenging New Year.

 

 [1] As a quick sidebar, on an aspect otherwise avoided here: non-audit services of a UK hive-off could readily be off-shored, with work delivered from a base in Paris or Brussels or Amsterdam – strategic moves separately motivated but feeding into the debate on the consequences of Brexit.  

[2] See, e.g, KPMG’s description of its international structure, here, and PwC’s 30-page global list of legal entities, here.

 

This concludes a series on the state of the UK environment, started back in September. Thanks for joining. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both on the Main page.