Re:Balance -- Jim Peterson

Private Equity Sings the Siren's Song; Grant Thornton Answers

It's always a pleasure to be a guest on Francine McKenna's Substack, The Dig. This from March 18 on a story where developments will be consequential:

The United States accounting firm of Grant Thornton, seventh largest of the global networks, announced on March 15 that it was selling a majority interest in itself to the investment firm New Mountain Capital.

Why the date was chosen will likely remain a mystery. Shakespeare’s invocation of the Ides of March to dramatize Julius Caesar’s bloody assassination in the Roman forum, however, suggests a comparison: Grant's forswearing its traditional partnership structure with the dazzling spin management of Marc Anthony’s funeral oration.

O judgment! thou art fled to brutish beasts,

And men have lost their reason.

As the partners/owners of Grant Thornton — the latest and largest of the mid-tier firms to embrace private equity — surrender their traditional status to become employees, it’s time to praise, not bury, the vexing challenges to maintaining professionalism when CPAs accept the golden chains of outside capital.

Where will Grant Thornton spend the money? What are its real ambitions?

The announcement itself is a word salad, the epitome of company-speak. “Quality” is referenced six times in seven paragraphs, “strategy” five, and “value” three. Grant's leadership provides no specifics regarding the expanded service offerings to be funded with its new wealth. Instead, it sticks to conspicuous vagueness, better to retain the flexibility to claim success whatever the future might bring.

A sound inference would be, however, that expansion of the Grant's audit practice is highly unlikely. There is a lengthening list of smaller firms withdrawing from the audits of publicly-listed companies in the US. Grant Thornton's United Kingdom firm has been winding down its presence in the large company sector (here and here). In 2018, it specifically said it was no longer interested in auditing large listed UK companies. The same should be assumed for the US, given that multinational companies require inter-connected global networks to deliver their audit services.

That leads even the casual observer to conclude that its growth ambitions – drawing on what the Financial Times says knowledgeable sources called an intended “war chest for investment” – are focused on the possible spectrum of non-audit consulting services.

Recall that the recent failed attempt to separate EY’s audit and consulting practices – the ill-fated Project Everest – was animated by the aggressive ambition of the EY consultants who dreamt of billions in return for launching an IPO of the consulting practice. (It would not have been the first time EY monetized its consulting practice in the last twenty years.) Feeding the downfall of the Everest mis-adventure was the absence of solutions to at least two parts of the necessary architecture. Answers to both challenges are reportedly included in the Grant Thornton project: provision for the partners’ pension rights, and separated “alternative practice structures” for the auditors and the consultants.

All this suggests at least the hint of a deeper agenda – that the outside capital for the Grant Thornton partners, which EY failed to secure, could be a down payment for a separation strategy. That possibility is not presently visible and even likely to be denied, but perhaps just over the horizon in the vision of at least some of the deal's advocates.

It’s not a crazy idea. Grant Thornton's modestly-scaled audit practice would be an appealing merger partner for another mid-tier firm bold enough to see a future in a traditionally-structured practice, while an independent consultancy underwritten by an angel investor could freely pursue its own path to possible growth and prosperity. 

Concern would be legitimate, however, for a worm lurking in this Edenic apple. There is prior unhappy history with “alternative practice structures,” for example, notably the short-lived cohabitation of H&R Block with McGladrey. And the SEC has warned about alternative practice structures and private equity investments in public accounting firms, in general:

...as some accounting firms may be considering changes to their capital and firm structures, we expect accounting firms to keep as their top priority a focus on their vital gatekeeper function.

The usual metrics that drive the private equity model do not align comfortably with the auditors’ duty to the public and obligations to public company shareholders. It would be an ill fit for the auditors’ exercise of prudence, skepticism and independence alongside the motivations of their new owners to seek and exploit investment opportunities with value to be unlocked through cost-cutting, dispositions and head-count reductions. 

It also sounds odd that the Grant Thornton press release describes the deal with New Mountain Capital as “subject to regulatory approval.” That's because neither the Securities and Exchange Commission nor the Public Company Accounting Review Board has a remit or any record of intruding into the structure, organization, or mergers and acquisitions activity of the audit firms operating under their oversight. Perhaps the comment was related to the role of state boards of accountancy?

Alternatively, it could reference the federal securities law and SEC/PCAOB rules on independence, particularly those involving bright-line prohibitions on financial interests in audit clients on the part of the firms themselves and their associated personnel and related and affiliated entities.

If so, it would be a warning shot across the bow of New Mountain Capital, because this new investment together with its April 2022 investment in the Citrin Cooperman firm would establish a three-way linkage for independence-impairment concerns.

It would surely make the regulators’ nerve ends quiver to think that the private equity sector, whose very business is the identification of otherwise underappreciated financial and economic advantage, would put itself in a role of dominant ownership of firms that benefit from the mandate in the securities laws that provides a protected franchise for those licensed to provide audits for public companies. Consider the temptations – an auditor knows a company’s strengths and more importantly its weaknesses – inherent in access to audit firms' access to all the skeletons and dirty laundry and, too, the existence of those financial cookie jars.  The value to an investor of a peek behind the curtains of auditor confidentiality would be enormous, and amply concerning to attract regulatory attention. Appeals to good behavior would be followed by official after-the-fact wrath when the inevitable lapses are discovered.           

Finally, however, this current version of Marc Anthony’s silver tongue may contain an irony worthy of his dissembling rhetoric. That is, it has been clear for years that neither the auditors’ traditional opinions nor their sprawling networks of inter-related country-level partnerships are robust in response to the current needs of the world’s capital markets.

The latter is displayed by the lack of interest of private capital itself in what the auditor does. The former lies with the clamoring public enthusiasm for different and extended forms of reporting and assurance, most dramatically in the crypto arena and now in the open-ended area of sustainability. The SEC’s wobbling on rules for climate risk disclosures, drawing lawsuits from both advocates and fierce critics of more disclosure, shows that neither the standards nor the approach to assurance are ready for prime time.

And yet, I have been urging for years that outside capital will be a necessary element for assurance to be fit for future purpose (on my blog, Re:Balance, back to August 7, 2011, and in my book, Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms, Emerald Books, 2d ed. 2017). I did not predict private equity to be the source. But, at the same time that its emergence — to fund the accounting firms’ desires to further expand services — further de-legitimizes the traditional definitions that undergird the long-accepted professionalism of the audit function, the consequence is to enable new services actually responsive to the needs of the marketplace.

In other words, Grant Thornton may – like it or not - be showing us the shape of the future.

 

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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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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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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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Re-Allocating the Big Audit Market in the United Kingdom – Or Perhaps Not

"Two aristocrats are out horseback riding and one challenges the other to see which can come up with the larger number. The second agrees to the contest, concentrates for a few minutes, and proudly announces, “Three.” The proposer of the game is quiet for half an hour, then finally shrugs and concedes defeat.”

     -- Mathematics professor John Allen Paulos, “Innumeracy” (Hill & Wang 1988)

Regulators and politicians in the United Kingdom may well disrupt the Big Audit model – judging from inquiries launched recently by the Financial Reporting Council and the Competition & Markets Authority. The series that began here on September 25 and October 8, started to address the misguided nature of the purported “remedies.” It is making for pretty heavy going – so with thanks for the opportunity to write this as guest for Going Concern, this to lighten things up a bit.

Grave as are the UK threats to break up the Big Four, strip them down to “audit only” or impose government appointment of large-company auditors, it would take a comedy script-writer to capture the folly by which, it is suggested, the Big Four would “voluntarily” reduce their dominant market share of the FTSE 350 from 97% to 80%.

The head of assurance for Grant Thornton in the UK offered on September 14 that a nationalized appointment authority, which “would take the buying decision from the company … could split audits, say 50 for the Big Four and 50 for the non-Big Four.”

Seriously intended or not, the idea comes oddly from those with expertise in the assessment and comprehension of quantitative information. What comes to mind instead is the stateroom scene in “Night at the Opera.”

To expand and explain -- by 2017 revenue, the ten large firms in the UK array as in the table below (in £ millions). Of their £ 13 billion total, the Big Four garnered over £ 11 billion or 86%. The trailing six firms divided the remaining 14%.  

PwC	3,598
Deloitte	3,380
EY	2,350
KPMG	2,172
Grant Thornton	500
BDO	429
RSM	320
Moore Stephens	181
Mazars	173
PKF	130

If the notion of shifting fully half of the FTSE 100 audits were apportioned by firm revenue, Grants would take fifteen, BDO twelve, RSM nine, and each of the others four or five.

Collectively, how ready and capable would they be? BDO presently has only one such engagement -- Randgold Resources Ltd – actually on the bubble at # 101 -- and that one is likely to go away with the September 25 announcement that the company is to be acquired by Barrick Gold Corp, an audit client of PwC in Toronto.

Grants itself once had a FTSE 100 client, until the stock price collapse of Sports Direct dropped its ranking to # 181. And in any event, that job is to move with the upcoming displacement of Grants thanks to the UK’s mandatory tender and replacement rules. None of the other mid-size firms audits a FTSE 100 company.

As graphically displayed here on September 25, the impact of scale is critical. No number of hours at the controls of a single-engine airplane can qualify a pilot, however skilled, to command a wide-body jet – much less a helicopter or a space shuttle or a stealth drone.

No less, and without a whisper as to the relative work quality up and down the table, the requirement of experience at the Big Four level in performing large-company audits with global footprints and necessary industry expertise is compelling.

So despite the reams of paperwork that will be generated through the inquiries of the UK regulators, it remains a solid certainty that nothing like the suggested 50/50 re-allocation of the FTSE 100 will ever happen.

Sooner the proponents, like Professor Paulos’s mounted aristocrat, eventually “shrug and concede defeat,” sooner the discussion can move to steps of possible achievability and beneficial effect.

 

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Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations

“No such thing as a failed experiment …. only experiments with unexpected outcomes.”-- American engineer-architect R. Buckminster Fuller

 Is the Big Four’s concentrated control of large company audits a real problem? Persistent voices of concern and attention extend back at least to the 2006 study for the Financial Reporting Counsel (here), recently joined by global leadership of BDO and Grants (here and here).

If so, is there a credible case to incentivize their exchange of market dominance for liability limitations?

Those issues were addressed this month in a paper from the American Antitrust Institute – here. In an all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With pending claims totaling billions of dollars, the Big 4 audit firms face serious threats to their survival…. (L)iability exposure substantially exceeds the combined partner capital of the Big 4 firms… (They) contend that liability limits are necessary to prevent the loss of another Big 4 firm, which would throw the global financial system into chaos. (footnotes omitted)   

The AAI’s suggestion would be a legislated trade-off: “government incentives to break up the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned on a firm divesting itself of, say, 20% of its domestic revenue and the personnel serving the surrendered clients.

Can’t work – because of the many problems with the underlying but unachievable assumptions. 

But before getting there -- the AAI deserves credit at least for recognizing the completeness of the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250 million” (emphasis in original) – with even tighter limitations on auditor choice in such industries as metals and mining, energy, air transportation and financial services.

Start with the political unacceptability of liability capping at a level that can assure Big Four survival. I have spelled out before (here) the financial limits of the large firms’ private partnership structure and their membrane-thin working capital, under which they cannot withstand litigation shocks above the $1 - $2 billion range – a tiny fraction (by either amount or percentage) of the exposures in their pending lawsuit inventory.

As the AAI paper summarizes, critics of liability protection point to the firms’ average litigation payouts, as a percentage of revenues and as compared to the far larger total of alleged damages. They fail to recognize – as do the arguments for capping from the profession itself -- that averages are meaningless when the “outlier” of a single verdict, falling outside the misleading comfort zone of a bell-curve model, could and would be devastating.   

So: because American politics offers no cover for protection at those levels, that side of the proposed AAI bargain is no solution. What of the other side -- the plausibility of large-scale competitors emerging from the suggested divestiture program? The facts dictate otherwise.

First, an abundance of small practices already exist. Why they have not coalesced into global-scale practices is a long-familiar story of limited geographic scope, expertise, risk appetite and readiness to invest.

Second, the smaller sector does not inspire confidence in its strength or capacity for quality growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a deathwatch, facing the post-appeal enforceability of its $521 million jury verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins just received a seven-year prison sentence – now faces the fall-out of being fired by Koss, its public but family-dominated Milwaukee client, whose CFO managed for years to steal amounts in excess of the company’s total net revenue (on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a practical matter, how would global-scale competition emerge? If a Big Four firm were to hive off a small geography-based practice, that newcomer would suffer handicaps of capacity and expertise no different that those of the current smaller firms.  If a large firm were to shed an entire industry practice, no new competition is added to serve that industry. And if instead, it were to divide a viable large-scale practice, then each of the two sub-practices would be burdened with shortages of expertise, personnel and the capital strength necessary to build to scale and withstand their risks.

In summary, the AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in logic I described (here) in the comparison of a failing situation against an idealized state, without recognizing that the assumed achievement is impossible under real-world limits, flaws and constraints.

The large firms grew that way for service-based reasons. And dreams of expanding the population of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the AAI’s most seriously under-examined assumption is that the “catastrophic” disintegration of another Big Four firm “would throw the global financial system into chaos.”

Why so? To the contrary, if the now-standard auditors’ report were suddenly not to be obtainable from any source, who would miss it?

Regulators and politicians would have convulsions, to be sure. But as the financial crisis itself has shown, that is daily practice for office-holders in the hermetic confines of Washington and London and Brussels.  

Should the stock exchanges be closed, if a Big Four failure meant that one-quarter of the large listed companies lacked an audit report? Could those companies’ securities be barred from trading? Unthinkable. Out where capital really flows and trade is actually engaged, the world’s markets would shrug, start the process of designing new forms of assurance from a blank page, and move on.

And the splintered pieces of the former Big Four would provide ample building blocks for a new assurance structure – without, pace the AAI, any need or use for the unintended and unpredictable hazards of another failed experiment.

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