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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The CPA Pipeline: Half-Empty – Half-Full – or a Conduit No Longer Fit for Purpose?

       

  “It’s your kids. We’ve gotta do something about your kids!”

                    Doc (Christopher Lloyd), Back to the Future, 1985

 

Commentators of all stripes are alarmed at a possible impending shortage of young accountants. They cite diminishing university enrollments, declines in candidates for the qualifying examinations, the time and cost commitment for a fifth university year, and post-COVID lack of enthusiasm for the long tradition of burdensome working conditions.

The AICPA’s biennial survey of graduation rates in American universities reported a year-on-year 7.8% decline for 2022 in the number of undergraduate accounting degrees, raising concern, as put by the Wall Street Journal on October 12, “as more workers in the profession retire without an adequate pipeline of entrants to fill the gap.”

The December issue of the estimable Accounting Today pitched “the pipeline problem (as) the most vocalized concern” of its designees as the profession’s 2023 top 100 most influential people (p.16).

To address the angst and agita, the Illinois CPA Society lauunched a survey on October 5, as reported by Going Concern on October 11, “to figure out why modern day accounting students and professionals are so uninterested in pursuing the CPA credential.”  

As always prudent, scrutiny is indicated – of the history, the data, and the perspectives being put forward.

To start, history’s long view is that, going back to the invention of trade and commerce, society has recognized and valued the functions of recording, reporting and assuring its quantitative information:

• Verifying for the pharaohs the costs of pyramid construction by matching the size of the labor force with the measures of wheat on which they were fed – an early example of the still-vexing problem of fraud detection and prevention.
• Keeping the books and calculating the profits and losses for the ocean voyages and spice route caravans of the Age of Discovery.
• Inventing independent audit in Victorian England to inform the complex pools of investor capital that funded the corporations building the infrastructure of the Industrial Age – a model that survives to this day.

Those needs are evolving, not going away.

A menu of concerns is offered. The WSJ cited “more onerous workloads … pay and burnout, mundane tasks, lack of meaningful work and the threat of new technology….” 

Brutal hours, trailing compensation, dubious advancement opportunities within the firms’ partnership structures, stresses of efficiency and performance quality under the looming presence of regulators and law enforcement – the environment is fraught.

Gen Z aired a plain and simpler view, with two comments in response to the Illinois CPA survey: “Everyone knows compensation is the issue,” and “the pay is crap and the life sucks.”

Notably, however, there is nothing novel in the persistence of the Dickensian work model – the current debate on mandatory return to the office has nothing on the Victorian vision of Bob Cratchit, toiling with quill and ledger on his high stool at Scrooge & Marley, obliged to grovel for permission to spend Christmas Day with his family. 

At the same time, inquiry is called for, whether the data cited in ostensible support of the “pipeline problem” are indicative of short-term fluctuations or longer-term trends.

The WSJ article compares, for example, the 65,305 accounting graduates in the US in 2021-2022 with 51,622 in 1994-1995 – a 25% uptick over a generation, with the percentage of universities projecting next-year enrollments to be the same or higher for 2024, increasing to 75% from 58% in the prior report.

Further, Purdue University’s highly-rated undergraduate business program is reported in Accounting Today as “defying the trend and seeing accounting enrollments growing dramatically.”

So it is in order to consider the possibility that there is special pleading in at least some of the hand-wringing.

Over in the UK, Sir Donald Brydon proposed in his lucid but unfortunately disregarded December 2019 “Independent Review Into The Quality and Effectiveness of Audit,” that the future of assurance will belong to professionals whose qualifications are drawn from multiple disciplines, beyond the traditional accountancy curricula. That’s a message for the academics: declining numbers of accounting majors might be viewed as canaries in the mine – signals of necessary academic re-engineering, however traumatic that may be to the career plans of department administrators, entrenched faculty, and tenure-aspirant PhDs.

Sadly, the Brydon proposals were met with indifference by the professional societies, lingering behind the curve of evolution, blinkered at the opportunity to broaden their scope and influence, fixated with the idea that the market should come to them, rather than the other way around.

As one head-scratching alternative instead, the Center for Audit Quality on behalf of the auditors of US public companies announced on October 10 a perhaps unique collaboration – a multi-year partnership with the Pittsburgh Steelers of the National Football League, to foster support of student interest in the field of accounting. 

Imagination stirs. The financial statements of a football club could include topics of real-world relevance and also pedagogically engaging: estimating a contingency provision for the impact of unpredictable career-ending injuries, or the amortization period for the cost of player contracts, or the timing of revenue recognition for advance payments to secure season tickets and VIP boxes.

Or, because such arcana might not suit student appetites and attention spans, if given game-day tickets they might apply in the stadium the skills needed as staff auditors - tracking between plays the net effect of in-and-out substitutions to assure that each team had precisely eleven players on the field - reinforcing the core proposition that debits always equal credits.

Student-worthy prizes and inducements might include the opportunity to audition for a Heisman House commercial, or the ultimate, to bring Mean Joe Greene back to Pittsburgh to re-enact his iconic jersey toss to the kid in the Coca-Cola commercial.

As for entry-level and early career compensation, the market would appear to be capable of adjusting. At the top of the curve, Deloitte as the largest of the Big Four announced on September 7 its global 2023 revenue of $ 64.9 billon - under-writing an increase in the percentage of US revenue going to staff compensation to 55.4%, up over four years from less than 50% (Financial Times, October 10, 2023), while at the same time sustaining handsome individual average partner pay, as reported, e.g. in the UK to be £ 1.06 million (about $ 1.3 million). 

The agility enabled by Deloitte’s robust results will not translate universally down the size curve. Instead, business models evolve. The structure of the modern profession was developed in the generation after Mr. Deloitte’s pioneering of the now-standard auditor’s opinion in 1850. Public company audits in the post-war decades were provided in the US by the then-Big Eight and Little Eight, now reduced to the surviving Big Four and a smaller handful.

With every other part of the world’s economies fundamentally altered beyond recognition over that period, it would be unthinkable that the long-established assurance delivery model should be expected or entitled to immunity from equally disruptive change.

Professional recognition, respect and legitimacy are not bestowed as of right or entitlement. Instead, the creaking survival of a model fundamentally unchanged for 175 years, when no other sector is recognizable over the same period, suggests that tectonic forces are at work, grinding slowly but building to an inflection point. 

That is especially the case because, sitting beside any supply-side concerns for the availability of new CPA feedstock is the symmetrical likelihood that developments in technology and artificial intelligence will influence the demand side. Impacts are coming, from re-definition of the functions and qualifications of the coming generations of accountancy professionals to the elimination of many of their current activities altogether.

The status quo will change. Opportunities will continue to be rich and varied. If there is a clear road to the future, however, it is tracked today on nobody’s map.      

 

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A Reality Check at the UK Audit Regulator: The Big Four Are Here to Stay – For Now

“If the fans don’t want to come to the ballpark, you can’t stop them.”       

Hall-of-Fame baseball player and philosopher/sage Yogi Berra

 And if the audit regulators don’t want to grasp an issue beyond their reach, you can’t stop them either.

Although, a problem postponed is not one avoided, but only kicked temporarily into the ditch.

That’s why it matters that Richard Moriarty, newly installed chief executive of Britain’s Financial Reporting Council, has accepted – as reported by the Financial Times –  that “it would not be a failure if Deloitte, EY, KPMG and PwC still audited almost all of the FTSE 100 by the end of his term.” 

In other words, quits at last for the ill-founded rhetoric, since Carillion’s collapse back in January 2018, that reductions in the Big Four’s dominant share of the large-company audit market would somehow be desirable or beneficial.

The position was blared to the skies: Labour MP Rachel Reeves, on her own and as chair of Parliament’s select Business, Energy and Industrial Strategy Committee, the Competition & Markets Authority as then led by Sir Andrew Tyrie, the FRC itself in its strategic plan of March 2018, and the Labour party’s shadow chancellor John McDonnell. 

Generously read, Moriarty’s fresh perspective can be taken for recognition that the challenges of auditor scale, geographic coverage, and distribution and accessibility of industry and other expertise – all left unaddressed by the cited critics as they kept silent on the means by which the mooted market disruptions might be accomplished - mean the end of the threats to displace the Big Four tetrapoly any time soon.

Or viewed slightly aslant, the persistent lack of political will, official energy and legislative attention to the accounting profession – manifest in the passage of nearly six years of inaction post-Carillion, and the acknowledged retreat by the government of Rishi Sunak from attempts to overhaul either the audit sector itself or its regulator – has intersected with the dawning realization that officialdom simply lacks the tools by which to re-shape the Big Four’s share of FTSE 350 audits.

In the months after Carillion’s demise, I addressed the vigorous hostility aimed at the auditors. A series of blog posts (here to here) came together in my short book, DOA: Can Big Audit Survive the UK Regulators? (Amazon 2019). There I laid out in detail the impossibility of re-distributing large company audits, whether by forced participation of smaller firms in joint engagements or in actual re-allocation of full-fledged lead auditor execution and responsibility.

In summary, the data starkly demonstrate the limits of the smaller firms – most succinctly captured in their global revenues:

• Although increasingly trailing its brethren, KPMG as it pushes toward $ 40 billion is still three times larger than BDO, at $ 13 billion the largest of the so-called “challenger” firms.

• And at $ 65 billion at the top of the table, Deloitte is some fifty to one hundred times larger than the firms implausibly included in the “challenger” roster.

My central points of four years ago were straightforward:

• “Concerns over the suitability of the Big Audit model cannot be addressed by attempted forcing of shrinkage on the large firms” (page 36).

• “Conceding the legitimacy of the concerns over audit quality, these will not be addressed by moving either clients or personnel from the Big Four to the smaller firms” (page 38).

• “The challenges of scale – geographic coverage, depth of expertise, personnel demands and financial resources – represent barriers to the emergence or creation of new players of Big Four size that are both natural and insurmountable. Those limitations – definitive on the prospects for either market share re-distribution or imposition of joint auditors with the involvement of the challengers – are no less conclusive on the question of ‘split up’” (page 49).

• “The demands of complex multi-country engagements will outstrip the capabilities of networks oriented to serve a small-country client base with limited personnel resources” (page 43).

• “The impact of scale is critical. No number of hours at the controls of a single-engine airplane can qualify its pilot, however skilled, to command a wide-body jet – much less a helicopter or a stealth drone or a space shuttle” (page 41).

• “No network smaller than the Big Four has a prayer of achieving the scale and resources to clamber into a competitive position” (page 37).

Looking back, what matters now is not the arrival of relief after years of Cassandra-like messaging, against a wall of denial, ignorance, and animus toward the Big Four. Rather, it’s what is to come. From the foreword of DOA: 

“Outbreaks of financial malfeasance and scandal are nothing new. They are both cyclical and inevitable in the operation of the capital markets – functions of the frailties and cupidity of human nature and the pendulum effects of less-than-efficient market mechanisms.”

Nor should the views here be taken as advocacy for the immunization of the Big Audit model from either criticism or the forces of change:

“The question is not whether the Big Four can survive in a form still fundamentally similar to that invented by their Victorian namesakes. It should be plain that under the combined public, regulatory and legal exposures, they cannot. The large firms have no inherent right to the preservation of their franchise in its current form – they are no more immune to the inevitable forces of evolution than were the dinosaurs or the steam locomotives.”

What deserves present recognition – although unlikely to be officially registered or acted upon – is that fresh financial scandals are gestating even now within the darker corners of the capital markets, only awaiting the conditions for their delivery. When the turn of that next predictable cycle does come, as it will with the certainty that has marked its predecessors for decades, the howls of public protest will sound as if fresh, “Where were the auditors?”

• The still-emerging impacts of the COVID pandemic and the dramatic uplift in interest rates are combining to put stresses on companies struggling to survive. They foreshadow a dramatic increase in company failures and bankruptcies, with resort by the unscrupulous to manipulations and chicanery aimed at evading reality, and with painful impact on investors and other sources of capital.

• Increasing numbers of auditor changes are the result of both adjustments of their client rosters by the larger firms and the expansionist ambitions of the smaller firms – all in the context of history’s lesson that problems in audit quality and performance are most frequently seen in the early years of a replacement auditor’s engagement.

• The current disengagement of the regulators from the basic issues will assure that the unlearned lessons available from the recent past will be sprung as if newly-invented when they befall a fresh generation of inexperienced bureaucrats.

To conclude – Richard Moriarty’s recognition of the structural imperative of the Big Four – under the current model – is a helpful and welcome step.

But there’s a basis for the emphasized qualifier. What Moriarty has achieved should not be over-stated. Critical concerns remain over both the value and the sustainability of the Big Audit model. And all the warnings remain vital and relevant.   

 

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NOCLAR: The Auditors' Impossible Task Under a PCAOB Proposal

 

"Why, sometimes I've believed as many as six impossible things before breakfast."

-- The Red Queen, Lewis Carroll's "Through the Looking Glass," 1872

As I was pleased to address today for Bloomberg, the American audit regulator is at it again:

The Public Company Accounting Oversight Board is promoting a flawed plan to escalate the responsibility of auditors for their clients’ noncompliance with laws and regulations, called NOCLAR. As proposed, the auditors’ duties would be new, expanded, and impossible to fulfill.

For context, current standards recognize that “whether an act is, in fact, illegal is a determination that is normally beyond the auditor’s professional competence.” Reflecting reality, the standards have provided since 1988 that an audit normally “does not include audit procedures specifically designed to detect illegal acts.”

The PCAOB’s draft rules would both raise the bar and obscure its height. On top of the standard for fraud detection (AS 23401), auditors would:

• “Identify the laws and regulations with which noncompliance could reasonably have a material effect”
• “Assess and respond to risks of material misstatement” caused by “noncompliance with those laws and regulations”
• “Identify whether there is information indicating noncompliance with those laws and regulations has or may have occurred”

Supporters of the proposal include PCAOB chair Erica Williams, who said, “We’ve seen far too many examples of investors getting hurt due to noncompliance with laws and regulations. And we’ve heard calls from investors for auditors to live up to their responsibilities. It’s time we answer those calls.”

The new standard “is a great step forward for auditor responsibility and empowerment, and for the protection of investors and the markets,” board member Kara Stein said.

However, opposition from corporate America and the large and small accounting firms on whom the burden will fall comprised the bulk of the now 137 comment letters posted to date. The comment period ended in August.

PCAOB member Duane DesParte, one of the two dissenters on the five-member board, said the “expanded scope raises concerns when coupled with the additional proposed requirement for auditors to ‘plan and perform procedures to identify whether there is information indicating noncompliance.’”

The lines of disagreement are drawn with a sharp and simple reason to be wary: The Big Audit model isn’t designed to meet the proposal’s expectations or to bear its consequences.

The only meaningful assessment of auditor performance is in the small number of cases that “go wrong,” with the inevitable question—"Where were the auditors?”—tested in the litigation or regulatory actions that arise with serious corporate malfeasance.

NOCLAR reporting has challenged audit practices for decades. In the courtroom, the plaintiffs’ script follows a crisp and successful template: The “audit plan” was incomplete or inadequate - the auditor’s “search” was insufficient to catch the illegality at issue - even assuming thorough planning and search, the auditors failed to identify and mitigate this particular wrongdoing.

The auditors’ defense is that as non-lawyers who aren’t trained in substance or procedure of criminal law, they were fooled by the concealed criminality of their malfeasant clients—no less than general participants in the capital markets.

DesParte flagged what would be a changed and more threatening environment: “While the proposal focuses the auditor on those ‘laws and regulations with which noncompliance could reasonably have a material effect on the financial statements,’ the filtering threshold of ‘reasonably could’ is not adequately explained in the proposal and is not addressed elsewhere in PCAOB standards.”

Under the proposed standard, the plaintiffs’ updated playbook would argue that a particular illegality or noncompliance should have been identified as material and that indicators of noncompliance that may have occurred were overlooked.

Translating DesParte’s diplomacy into the ruder language of litigation exposure - if anything, the proposed standard’s ambiguities and imprecision would mean that defense of the auditor’s work would become even more difficult, not less.

Compounding their difficulty, the auditors could expect little help from their clients’ in-house or outside counsel. The lawyers’ long-running protection of their privileged client communications (see the US Chamber of Commerce’s comment letter) enables a black hole in corporate reporting, by which the lawyers pretend to be unable to quantify their litigation and contingency assessments, while the auditors and information users pretend to believe them.

Going forward, the deserved scrutiny of the PCAOB’s proposal would compare the proposed standards with expectations under the old. A useful exercise would back-test recent examples. If the proposed standards had been in place, would there have been any difference in PwC’s audits of Colonial Bank? Or in Deloitte’s audits of Taylor Bean & Whitaker?

Those exposed illegalities may be the easy cases. What if the inquiry were more nuanced? Would KPMG’s procedures have differed in its audits of Silicon Valley Bank, where the question of legality still needs unpacking?

Or this: Verizon and AT&T recently have been sued in investor class actions over their failure to recognize the remediation costs of lead-clad cables, long since abandoned underground.

While no auditor’s risk assessment would wish exposure under both the environmental and securities laws, the auditors are flirting with the former—see the International Auditing and Assurance Standards Board’s advocacy of its proposed Global Sustainability Assurance Standard—while the scope of auditor diligence under the NOCLAR proposal is hardly likely to extend to ancient cables long buried and forgotten.

Comment letters on the proposal urged further public input, whether by task force, roundtables, or field testing. These might gracefully allow for reconsideration and retreat from the backward formulation of the PCAOB’s motivation, even as Williams contends the board’s majority is “simply making sure that the protection investors think they are getting today matches what the standard requires.”

That articulation should be concerning. A standard based on what one of the affected constituencies “thinks they’re getting” has it the wrong way around, even if the auditors are too delicate to say forthrightly, “we can’t” or too timorous to step up with “we won’t.”

For the sake of its credibility as it strives to show its value, the PCAOB should demonstrate better diligence over a proposal with potential for such dramatic unintended consequences.

 

Originally published at Bloomberg Tax Insights & Commentary, September 8, 2023, and reproduced with permission. Copyright 2023 Bloomberg Industry Group, Inc. (800-372-1033) www.bloombergindustry.com.

Alert for readers here, although too late to footnote in the Bloomberg version: on September 1, Francine McKenna provided a fulsome tour of the history of company reporting for litigation and other contingencies on her substack, The Dig -- both a helpful primer for new arrivals to the NOCLAR topic and a useful reminder for veterans of the long and tortured relationship between auditors and lawyers.    

 

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EY’s Project Everest and Stockton Rush’s Titan –- A Comparison of Two Wrecks

"The Defense Department regrets to inform you that your sons are dead because they were stupid.”

            Goose to Maverick, Top Gun, 1986

 An exam essay for my graduate-level course in Risk Management and Decision-Making, out of this spring’s two catastrophic implosions:

• Stockton Rush’s submersible Titan, crushed in a nano-second on its descent to take an expensive porthole peek at the disintegrating wreckage of the Titanic, lying 2100 fathoms deep on the floor of the North Atlantic.

• EY global chief executive Carmine DiSibio’s aborted Project Everest, by which he sought but failed to split and separate the accounting and consulting practices of the Big Four network.

Here it would be:

As an exercise in “failure study,” compare and contrast the attitudes and behaviors of Rush and DiSibio, and the sources of bias, error, mis-judgments and other factors contributing to the collapse of their ambitious aspirations.

This course seeks lessons for business, professional and personal choice-making. The semester has just ended and my terrific student cohort has scattered on their summer holidays, so here’s what I would have expected from them –- a comparative exercise in how central themes in human behavior are found and recur across a broad range of examples.

While the literature on flawed decisions is rich with guidance, it converges on the deadly combination of arrogance and ignorance. Over-confident commitment to a triumphal goal –- a visual close-up of the historic wreck site, or the cascade of riches anticipated from the EY separation –- would suppress any appeal to proceed with caution, prudence and counsel with the available expertise of others in the sector: hull design, incremental trouble-shooting, and inclusion of safety and emergency capabilities, on the Titan –- and for Everest, coherent strategic planning, globally functional leadership, and resolution of organizational inadequacies in governance and infrastructure.

Innovation, evolution and boldness of vision lie at the heart of great plans, to be sure. But not even unlimited financial resources can purchase a repeal of the inexorable laws of physics and metallurgy and marine engineering –- nor can boundless hubris and grandiosity evade or bypass the basics of economics and organizational dynamics.

The comparisons extend. The hydrostatic pressures on the hull of the Titan were calculable in terms of the water’s depth and density (P = pgh, for those interested) –- predictably catastrophic forces on a vessel of sub-optimal shape, inadequate testing, and fatigued by multiple descents.

As turns out, the formula has application, by analogy at least, to Project Everest –- the depth of its problems went unmeasured and untested, and the density of its leadership created destructive forces beyond recovery.

There’s one further comparison, grisly in its nature, in an expert engineer’s analysis:

• The Titan’s malfunction and loss of power, de-stabilizing and tipping it out of control to “fall headlong towards the seafloor,” meant that its five passengers –- helplessly piled in the nose of the cabin without lights, communications or workable emergency measures -- likely had about a minute of terrified awareness before its fatal failure.

• Likewise, the plain take-away for Carmine DiSibio in the failure of his head-to-head with EY’s American leader and deal skeptic Julie Boland was that the lights were out on Project Everest, a crash was imminent, and there was no available rescue plan or exit strategy.

Stockton Rush’s mis-adventure in “tourism porn” –- charging obscene ticket prices for a reckless project having no legitimate purpose within the protocols of real science, but induced by incentives lying elsewhere in egoism, emotion or ambition –- will be no more than a blip on the future of deep-water exploration. Further analysis is to come, but early post-mortem reporting on the recovered remains already indicates that the causes of the Titan implosion are well understood in the surfeit of flaws in its design and execution.

The same for Project Everest, and DiSibio’s frustrated conflicts as the would-be leader of a new, publicly-listed consulting enterprise. The debate will continue about the desirability of alternate models for professional services, as across the spectrum from integrated, full-service firms to “audit only” assurance practices completely separated from the expanding array of consultancies in Sustainability, cyber security, artificial intelligence and otherwise. But because history’s best example of the latter is the mixed outcome of the Arthur Andersen divorce of 2001 –- the immense success of the Accenture IPO and that company’s powerhouse growth thereafter, contrasted with the death spiral of the Andersen accounting firm in less than a year –- the next entrepreneur tempted to dive into these cold waters will be wise to study with care the uncharted hazards beneath the surface.

“What will kill you is ‘not knowing what you don’t know’” -- the maxim is captured by the academics as the Dunning-Kruger effect. Critically for lessons to be learned, any complex situation with a non-zero possibility of potentially fatal problems calls for pauses and consultation, analysis of emergent quality issues, and careful attention to dissenting views and disaffirming evidence.

Which apparently did not figure for either Rush or DiSibio –- meaning that the outcomes of both projects were fore-ordained. Titan and Everest are now reduced to rubble and mourning, for reasons traceable to the conduct and behavior of their sponsors and advocates. Further efforts in either area may benefit from their unhappy experience.   

 

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EY's Collapsed Split Attempt -- Questions for the Audit Model

The collapse of Project Everest, the doomed attempt by accounting giant EY to split its consulting and audit practices, leaves a landscape like a medieval battle-field -– strewn with casualties and be-set by looters.

The mood is dour –- a retired partner sees “a lot of animosity within the firm,” and an academic says that “short-term turmoil and leadership changes are probably going to happen.” Job cuts were announced for the local firms in the US and the UK.

Uneasy lie the heads that wear the crowns: Carmine Di Sibio, EY's global chief executive; UK managing partner Hywel Ball; their principal antagonist Julie Boland in the US. The tenures of EY’s leadership are in the balance, along with the cohesion of the network and its $ 45 billion of 2022 revenue.

Renewed questions are now aimed at the fitness of the Big Audit model -- see Bloomberg, the Financial Times, and The Economist. As reporters Amanda Iacone and Michael Rapaport put it (all emphasis added):

“Experts say some problems are baked into the very way audits are structured, and that the system actually provides incentives for auditors not to do a tough audit. It’s hard to change that without scrapping the whole system and starting from scratch.”

That view is not shared by the participants. The compensation packages of the partners are linked by golden chains to the unexamined verity of an outmoded product from the Victorian era. That they might willingly imagine a different world would be unthinkable.

Except that it’s not. The depth of EY’s wounding is yet to be felt, with the potential loss of clients, practice stagnation, and the poaching and flight of disaffected personnel. “Expedited hiring discussions” are initiated by opportunistic competitors, and at least two life-threatening litigations are looming –- NMC in the UK and Wirecard in Germany.

It is well to remember that kernels of supposedly eternal truth are ground to dust in the mills of the gods:

• Galileo’s 17^th century inquisitors were piously confident that heliocentrism was divinely condemned.

• “If God had meant man to fly, He’d have given him wings.”

• “I think there’s a world market for maybe five computers,” said IBM Chairman Thomas Watson in 1943.

Irony not being a Bloomberg characteristic, its writers’ question deserves serious and expanded treatment:

“Does the current way of doing things need to be scrapped and rebuilt from scratch, then?”

“What if” the disintegration or collapse of EY? And the unavoidable consequence: an unsustainable Big Three model that would make unavailable, at any price, audit reports for the world’s large companies.

Vexing issues gathered by Bloomberg confront the accountants, with hands wrung in angst and frustration –- here summarily re-cast as “the latest flare-ups of a rolling, seemingly intractable series of crises over audit quality, the role of consulting, and auditors’ integrity”:

• The firms pronounce that audit "is at the heart of the DNA of these firms…They all take very seriously their public interest role…”, and regulators assert that “We’re confident that audit quality has improved, at least at the biggest firms” –- despite persistent outbreaks that at minimum suggest the contrary.

• “The firms, their critics, and their regulators have tried for 25 years to solve the industry’s recurring problems -– but while some observers say audit quality has improved by some measures, failed audits and corporate collapses haven’t stopped.”

• “All of the Big Four firms have had significant audit blowups in recent years” -– see the current attention to KPMG as auditor for the “three-fer” of recently failed American banks SVB, Signature and First Republic.

• “(A)uditors maintain that they actually aren’t responsible for doing as much as investors think they are –- something the auditors call the ‘expectations gap’.”

• “Even as rulemakers contemplate setting high bars for auditors, regulatory enforcement of those rules historically has resulted in penalties that amount to a slap on the wrist…”.

• “In theory, an EY split could help alleviate conflict-of-interest concerns, but … a break-up could hamper EY auditors’ access to expertise, specialists, and technology from the firm’s consulting side.”

• Quoting a plaintiffs’ lawyer, “I don’t think anyone believes what the auditors say anymore…They don’t see any risk to being wrong or to not uncovering something, where there is a risk to uncovering something.”

Hypothesizing a failed EY and a future in which the traditional opinion is no longer obtainable -- resolution of all the above issues is available in that future:

Assurance providers would be freed from their shackled role as “statutory auditors” and enabled to provide targeted, bespoke assurance, extending to all or portions of company information, both financial and as to Sustainability.

The over-hang of death-threat litigation would lose its significance. The “expectations gap” would be closed, as opinions would be delivered under contracts defining third-party reliance and caps and limits on liability.

Firms freed to offer a full range of assurance would hire the equally broad range of required talent and expertise. Career paths would open up. Limitations of auditor independence and constraints on scope of service would have fallen obsolete.

Comprehensive global presence and scale no longer being essential, new providers could offer niche services under new structures and capitalized by new sources –- superseding current concerns for limited competition and range of choice.

Rather than answer to the narrow prescriptions of the regulators, disclosures and assurance would be testable and evaluated in the capital markets.

• Anticipating the anxiety of the bureaucrats, however, nothing in this brave new world would eliminate either issuer responsibility for appropriately defined disclosures to investors or suitable oversight of assurance providers.

No prediction, when or whether a Big Four network might collapse like Arthur Andersen in 2002. But it would be reckless to believe that it cannot or will not happen. 

That possible future, however, should not be so scary as to self-censor an exercise in scrutiny that needs be both thorough and candid. 

 

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Silicon Valley Bank -- When a "Standard" is not a Standard

Guest-posted on April 19, with pleasure, on Francine McKenna's sub-stack, The Dig:

KPMG, auditor for failed Silicon Valley Bank, has been included as a defendant in a securities fraud case filed April 7 in the federal court in San Francisco — along with directors and officers of the bank and its underwriters Goldman Sachs, Bank of America and Morgan Stanley.

It won’t be the last. SVB failed back on March 10, and the only surprise is that it took so long.  

KPMG’s clean audit opinion on SVB’s 2022 financial statements was delivered February 24, three weeks before the bank’s closure by the California Department of Financial Protection and its takeover by the FDIC as receiver. The firm and the other defendants are charged with misrepresenting SVB’s balance sheet, liquidity and position in the market and by understating and concealing the magnitude of the risks it faced.

The plaintiffs, led by the City of Hialeah Employees Retirement System, claim that auditor KPMG did not qualify its opinion for doubts as to the bank’s ability to continue as a going concern, and did not identify as a “critical audit matter” the impact that rising interest rates could have on the unrealized losses on the bank’s bond holdings and its ability to hold those bonds through what was the potential, and eventually destructive, flight of customer deposits.  

If it feels like a somewhat geeky sequel to a movie we’ve all seen before, it should.

The comparison has long been available that — just as professors of literature teach that there are a small number of great plots that have been revised and recycled through the history of Western culture — so too the inevitable periodic outbursts of financial malfeasance come in cycles with a handful of recurring themes.

A partial list of examples — paired up so that by squinting and some flexibility, parallels may be drawn:

A hero comes to save the people from a monstrous threat: David v. Goliath, Rashomon and The Magnificent Seven, Jaws, Blazing Saddles 

Schemers loot the savings of the credulous: Charles Ponzi, Bernie Madoff, Elizabeth Holmes, Sam Bankman-Fried

The comic effects of mistaken identities: Plautus’s Menaechmi, Shakespeare’s Comedy of Errors, Oscar Wilde’s The Importance of Being Ernest 

Assurance providers fail to properly “count the stuff”: The mis-weighed beans in the 1920s, Tino DeAngelis’s fictive tanks of vegetable oil in the 1960s, the € 1.9 billion found in 2020 not to exist at Wirecard

Inter-generational conflict: The House of Atreus in both Greek myth and the plays of Aeschylus, Shakespeare’s Henriad and also King Lear and his fractious daughters, Coppola’s Godfather trilogy, today’s Succession

Accounting principles tortured into misapplication: the netting of accounts at Continental Vending, the Arctic oil leases held by Investors Overseas Services, the special-purpose entities at Enron, the long-term contracts at Carillion

Over the centuries, the rocky course of young love: Hero and Leander, Romeo and Juliet, the romantic mis-adventures of Emily in Paris

The devastating effect of mis-matched interest rates in the strategies of financial institutions, going back to the American savings & loans of the 1980s and the sub-prime mortgage portfolios of 2007-2008, and now erupted at, among others, KPMG clients SVB and Signature Bank

It is, of course, no less predictable that fresh outbursts of financial chicanery will re-trigger the usual reactions, just as authors, playwrights and scriptwriters will reprise the classic themes:

• Hand-wringing accompanies the cry, repetitive but hollow, “Where were the auditors?”
• Regulators and oversight agencies spring into action.
• Lawyers for investors sprint to the courthouse, lawsuits in hand.
• Academics and other commentators get attention from the business media, while jostling to be engaged by plaintiffs as well-paid “experts.” 
• Renewed rounds of recrimination, blame-mongering and futile attempts to alter human behavior capture public attention but only briefly and with minimal effect.

If this sounds like a tragicomedy, it’s not as if we haven’t seen this show before. Rather, if the implications of “same old, same old” are so obvious, why haven't we learned from the past?

One place to look for an answer is the hindsight perspective of the critics. Pinning it on the expectation of a “going concern” warning is futile. Good guidance for practitioners has been an intractably elusive challenge for standard-setters for decades. Such an opinion qualification is a “nuclear option” that auditors are passionate to avoid because the company may immediately be in breach of loan covenants. Or worse, for lack of a plan to recover, the qualified opinion becomes a self-fulfilling prophecy.

As for CAMs —and their analogs elsewhere in the world where “key” is substituted, thus KAMs — their availability and use have been gradually creeping into practice since introduced via the International Auditing Standards in 2016 and imposed by PCAOB requirements with application starting in 2019.

Wider use, however, has not made C[K]AMs more illuminating, reliable or demonstrably useful to information users. The limited available scholarship on their ability to signal future issues is no better than mixed, since there's no good research proving up the questionable hypothesis that investors actually pay attention to CAMs or make real-world decisions based on their inclusion in corporate disclosures. And there is at least anecdotal evidence that, in fact, they do not. That includes instances where fresh inclusion of a CAM or KAM was met with the typical indifference of investors and negligible effect on the reporting company’s share price. 

Reporting in the Wall Street Journal is provocative with regard to the prospects for the SVB litigation, and whether it will be persuasively argued that KPMG’s professional judgments deviated so far from acceptable practices as to sustain a successful claim for the plaintiffs.

WSJ reporter Jean Eaglesham writes that, on the one hand (emphasis added):

“Auditors for nine other U.S. banks most exposed to bond losses also didn’t flag this as an issue…"

“The Journal reviewed the audit opinions for the 10 small to midsize U.S. banks that last year reported the highest losses on held-to-maturity securities as a proportion of their shareholder equity… Silicon Valley Bank ranked second on the list."

“None of the auditors included a critical audit matter related to the bank’s treatment of the bonds. Instead, nine of the 10 reported a critical audit matter for estimated losses from loans or other bad debts.”

And, on the other hand:

“Silicon Valley Bank’s unrealized losses in its bond portfolio appear to ‘meet every definition of a possible critical audit matter,’ said Martin Baumann, a former chief auditor at the PCAOB who had a leading role in designing the new measure.”

And further:

“That appears to tick all the boxes for the auditor to highlight this issue as a critical audit matter. ‘The judgment as to whether or not Silicon Valley Bank had the ability to hold these securities to maturity was certainly a complex question, it was material to investors, and it is hard to see how liquidity was not a matter for discussion with the audit committee,’ said Mr. Baumann, who is also a former senior partner at Big Four audit firm PricewaterhouseCoopers.”

In a world where standards are well-designed and dependably applied, and where liability is imposed in a way that can be perceived as both predictable and fair, the two positions — disclosure decisions of the various auditors for group of small banks, and the attribution of liability to KPMG — cannot be reconciled. They cannot credibly co-exist.

That is, after years of disrespect for the audit profession’s attempts to improve the discipline in their processes, the distasteful choice is between elevating “box ticking” by hindsight to the status of a threshold for liability (insert sarcasm emoji here), or finding that the bar for liability has sunk so low that it requires a serious evaluation and re-set.   

That's not to say, at this point at least, that KPMG’s audit performance will be assessed as above reproach. We shall see as the litigation runs its course.

But in that context, it bears noting that back in a happier era before the hijacking of audit standard-setting by regulators under the pernicious influence of the Sarbanes/Oxley law of 2002, the term “generally accepted” had its literal meaning. That is, actual application of standards was observed in practice, tested for usefulness and practicality, and adjusted incrementally; opportunities for evolution and improvements could be taken without the querulous intrusion of censorious bureaucrats.

All changed, and not for the better. If the harshest allegations now brought forward are based on KPMG’s good-faith judgments to omit either a CAM or a going concern opinion paragraph, then — to borrow a metaphor from the world of the theater in that nostalgic time — the plot is so thin that this production should close in out-of-town previews.

 

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Demise of EY's Project Everest Stems From Self-Inflicted Wound

No one should be surprised at the canceled split of EY’s audit and consulting practices following a confrontation between the firm’s global and US leaders. But a post-mortem period of recriminations, blame-mongering, and blood-letting is inevitable.

That's the lede of my guest post today on the home page of Bloomberg Tax, with thanks for the opportunity:

Carmine Di Sibio’s mountain has fallen to a pile of rubble.

The aspiration of EY’s global leader to separate the Big Four firm’s audit and consulting practices under the grandiose title of Project Everest was announced on April 11 to have failed. A post-mortem period of recriminations, blame-mongering, and blood-letting is inevitable.

No one should be surprised. Two weeks of silence on the resistance of EY’s crucial US firm after the late-March confrontation between Di Sibio and US leader Julie Boland spoke to the deal’s imperiled state. Project Everest’s trajectory went from a strategic imperative to re-engineer Big Audit to an abrupt collapse labeled “chaos” by EY’s own partners that will feature as a case study in business school curricula.

Preliminary conclusions are already available. The memorandum of capitulation by EY’s global executive team, which dangled the notion of a future revival, listed the requirements: “to adapt our governance, operating model, cost structures, capital investments, and go-to-market approach.” It didn’t acknowledge that each of these was identifiably inadequate when Everest was announced.

Looking back on the face-off between Di Sibio and Boland, the Americans’ stated concern was the allocation of EY’s tax practitioners—between a new consulting practice with its planned public listing and cascades of financial benefits, and the legacy audit firm staying behind in a traditional partnership structure.

There’s much more. The echoes of surrender were still reverberating on April 12, when Boland announced a US strategy and cost-saving program. It’s a complex aspiration on its own and clearly a card she held closely in the weeks of wrangling with Di Sibio.

Going forward, Di Sibio’s credibility must be fatally wounded despite global messages; Boland will be non grata among large and disappointed portions of EY’s various partnerships. But she has the US firm tagging $500 million in savings—a handy bucket she can claim by dropping the foregone costs of canceled recruits and staff defections.

Inside EY, there’s some sympathy. It’s to be hoped that the consultants anticipating multimillion-dollar IPO windfalls were restrained in their eager down payments on vacation homes, bigger boats, and fancier cars. Meanwhile, poaching will advance. Individual partners will test the waters to affirm the handsome valuations they’d been led to believe they represented. Some, at least, will be met with open arms.

And where now, for the contours of global Big Audit? Although EY posited that its practice separation would be a “road map for reshaping the profession,” and urged that it would “inevitably be copied” by its brethren, Di Sibio might regret the move.

Early reactions from other large firms ranged from quiet skepticism to downright disdain in an in-house video from Deloitte’s global leader, Joe Ucuzoglu. To say they’re having a moment likely understates the muted snickering behind closed doors. In Australia, KPMG’s leader Andrew Yates was quoted that “the deal’s collapse showed that clients still wanted a one-stop shop.” To the same effect, Deloitte’s Adam Powick said “we have been unwavering in our commitment to our multi-disciplinary and private partnership model.”

Advocates for the large firms’ retention of the ancillary expertise necessary to carry out global-scale audits—tax and appraisal, and evaluation and crypto and cybersecurity--may not have won an outright battle. But those arguing that an “audit only” firm can hire or outsource those necessary resources are now disarmed.

Most important, the anticipated stream of defections hopefully will be moderate enough to leave behind a stable firm. The Big Four tetrapoly that survived Arthur Andersen’s 2002 collapse is down to a critical minimum. A three-firm model might be unsustainable under existing scope of practice limitations and uneven global distribution of resources and expertise.

The emergence from this dark period of a vital EY affects the survival of the Big Audit model itself, at least in its current form. However, EY’s survival as an essential player depends on its leaders’ ability to face and resolve a set of challenges:

• Satisfy its uneasy clients that engagement quality has not suffered;
• Recast internal messages to return to work after the massive distraction of nearly a year of speculation and uncertainty;
• Ramp down any misrule among the resident troops; and
• Reach out to recruits and applicants with whatever assurance can be mustered that adults are in charge and have their interests at heart.

As Di Sibio feels his once-shining star fade to a cinder, he may find a bit of solace in the emollient words of a niche London consultant: “The fact that this deal, as constructed, now seems unlikely to go ahead doesn’t mean that the thinking that underpinned it was wrong.” Translated from the jargon of someone angling to be hired in the future, this means, “Sorry, you blew it—perhaps another time, although not likely, and not on your watch.”

With EY facing a distinctly clouded future, the book-makers running the betting pool on the over/under date of Di Sibio’s retirement are no longer accepting wagers.

 

Reproduced with permission. Published April 13, 2023. Copyright 2023 Bloomberg Industry Group 800-372-1033. For further use please visit https://www.bloombergindustry.com/copyright-and-usage-guidelines-copyright/  

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The Endangered State of EY's Split-Up Strategy

As I am pleased to discuss today as a guest on Francine McKenna's substack, The Dig -- whether or not EY actually does split, there are big implications for capital markets and professional service providers.

 

#1 on Billboard’s Hot 100, August 1962

 

Nine months on since last May’s revelation of EY’s plans to break up its audit and consulting practices into AssureCo and NewCo, freshly reported opposition from its US leadership has thrown the entire project into disarray.

Ernst & Young has paused its plan to spin off its consulting arm, bowing to pressure from its U.S. partners to rethink how the tax practice will be divided when the firm is split into two, according to people familiar with the matter.

As I put it in August, global CEO Carmine Di Sibio’s Project Everest looks increasingly to be “a hill too steep to climb.”

Allocation of the firm’s tax practices is said to be the sticking point, with the Financial Times reporting “‘chaos’, ‘low morale’ and ‘infighting’ at the firm,” while both deal details and the necessary country-level partner voting have continued to slide. 

As fully unpicked in this weekend’s Financial Times, outstanding uncertainties include:

• Resolution as to which of the 150-plus country practices and who among the thousands of employees will participate.

• Resolving whether to cut retired partners into the expected pay-outs.

• Allocation of legal liabilities, notably for the overhanging large litigations.

• Reduced value for the mooted IPO of a newly-created consulting enterprise.

• Fundamental challenges to raise necessary capital and achieve handsomely-projected growth rates.

• Persuading both existing and prospective clients of the ability of the bifurcated businesses to be competitive for value and quality.      

Large-country partner votes have slipped from last November, reportedly to April, but with the latest news suggesting they are now delayed indefinitely. NewCo’s IPO still aspires for late this year or perhaps now into 2024.

It’s an understatement that grounds for skepticism about Project Everest persist. Irrespective, there remains a serious concern -- namely, the very stability of Big Audit itself — the franchise by which the four networks that survived the collapse of Arthur Andersen in 2002 emerged to dominate the provision of audits for the world’s largest public companies.

Whatever its outcome, succeed or fail, the very launch of Project Everest has put EY’s structure and stability in play. Either way, that presents an existential threat to Big Audit, under the inevitable degrading of EY’s capability, because the survival of the Big Audit model itself depends on the continued health of the entire quartet of providers. Its number cannot realistically be reduced below its current critical limit. 

Suppose the Proposal Fails

For whichever among the lengthy list of possible reasons, there will be an inevitable burst of snarky criticisms. There will be time enough to savor the business school case studies written about a deal conceived in weakness and bungled in execution. Rather, if the audit partners were forced to remain in hostile cohabitation with the disappointed consultants whose lofty NewCo aspirations failed to materialize, consider the state of AssureCo’s internal morale, mutuality of commitment, and operational dislocations.

Carmine Di Sibio’s days would be numbered. He and his team would be fatally wounded as leaders, and the replacement process would be immediate. At best an uneasy peace might hold, while the process unfolds.

With the deflation of their rainbow-tinged expectations, the consultants would be disgruntled. Many would be inspired to pursue smaller, achievable niche transactions, and it would be open season for poaching. (The Financial Times report that PwC has a target of up to 500 EY partners in the US reflects the atmosphere; Alvarez & Marsal has announced its appetite and has already picked up a large practice group from EY China.) 

On top of the need to massage uneasy clients, the environment in the audit practice would be fraught. The energy sucked away by Everest — at a cost reported by the FT “set to rise to about $2.5bn by completion even before banks such as Goldman Sachs and JPMorgan take their fees” — means that engagement teams would re-assume their battle stations under extended stresses of time and budget.

Audit teams would be obliged to reach out to their consulting brethren as in the past, for the ancillary expertise necessary to do complex audits. But strained relations and inefficiencies would be predictable, especially if a critical mass of consultants were primarily aiming to negotiate the best achievable departure terms.   

Recruiting would be challenged. On the massive numbers, the firm’s announced hiring spree may either simply reflect that the Big Four continue to be employers of first resort for whole battalions of entry-level cannon fodder, or cover for predicted levels of turn-over, or more ominously, a whistle past a dark and uncertain graveyard.

As for retaining both staff and targeted veterans at the partner and manager level (see Bloomberg’s Amanda Iacone on February 15),  there would be limited attraction in an offer to join or remain with an enterprise where career aspirations go to die.

Suppose the Deal Succeeds

Suppose Di Sibio does achieve his plan to lead EY’s consultants toward a promised land of unconstrained opportunities and munificent rewards. He'd take with him as many A-players as the negotiations would tolerate from among the experts in tax, valuation, cyber security, blockchain, crypto, and all else under the broad heading of Sustainability.

Future events would determine both whether optimistic sources of public or private capital will splash out to enable the much-touted paydays, and whether a newly free-standing consultancy might rocket to success as the next Accenture, or achieve mediocrity in a crowded and competitive field.

That’s a matter of indifference to the capital markets, whose concern must be for the future of AssureCo.

Left behind in that legacy practice would be a rump of tax and other resources, staffed by those either uninterested, unwilling, or uninvited to join the exodus in search of greener pastures. AssureCo as a critical player in Big Audit would find itself challenged to retain, hire, or engage from the outside the resources needed to serve its book of large-company audit clients. 

A key challenge would be the simple one of execution, which has two parts.

The first is in carrying out large-company audits, where audit teams rely of necessity on their colleagues’ ancillary expertise. Consultants at NewCo would not be eager to be re-engaged as audit support, having forsaken EY’s network structure precisely to avoid the constraints of audit. Nor would third-party providers be in ready supply — having no more appetite to limit themselves under the rules of independence and practice limitations that they presently avoid.

And while a part of the pro-split messaging has been that AssureCo would set out to rebuild, replace and grow the practices departed to NewCo, the logic breaks down. That’s because the building of any new non-audit practice would confront the same limitations that are now driving Project Everest. That is, all those who believe that a successful consulting practice is incompatible with auditors would either have exited a combined practice in the first place or would shun a re-building effort in the second.

As for additional factors affecting what must be an atmosphere of uncertainty for EY’s audit partners, there are several.

Those of a certain seniority will be weighing their readiness to hand-hold a portfolio of uneasy clients, against the personal appeal of promptly cashing out whatever incentive payments emerge from the deal and heading for the retirement door. Non-competes, lock-ups and clawback provisions would be only reluctantly enforced — the morale impact of keeping an older cohort “retired in place” would be too gloomy to contemplate.  

The legacy firm will presumably be negotiating to retain the assets and liabilities appropriate to its practice — relevant if relatively inconsequential interests in real estate, methodologies and intellectual property, together with properly identified pension commitments and funding obligations.

But under an estimated reduction in global revenue from $45 to $18 billion, AssureCo would confront its future litigation and law enforcement exposures in a seriously weakened condition. In raw terms, its on-going capital structure and liquidity would have been severely eroded in the negotiations to deconstruct the EY global balance sheet.

Nor is there any reason to think that the departing consultants might agree to a “golden good-bye” adequate to satisfy EY’s current overhang of audit-related litigation, much less to assume any responsibility for the inevitable future outbreaks. For one specific, a matter of current attention and likely contention would be EY’s captive insurance program — a “cookie jar” funded by the willingness of the partners to make sacrifices in their current earnings, and not likely to be surrendered gratuitously by those departing.    

To conclude, the 17^th century French storyteller Jean de LaFontaine put the caution against hubris and over-confidence:

“Ne pas vendre la peau de l’ours avant de l’avoir tué.”

“Don’t sell the bearskin before you’ve killed the bear.”

The Americans’ opposition will not be the end of it. The mischievous energy of disruption has been released, and will not be tamed easily or without consequences.  

 

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Dispatch from the UK: KPMG Settles Carillion –- Whiners Are Not Happy

Guest posted today on Francine McKenna's Substack, The Dig -- a pleasure as always.

 

KPMG has settled the £ 1.3 bn claim brought against it by the liquidators of its client Carillion, the UK outsourcing behemoth whose spectacular collapse in January 2018 triggered an outpouring of the too-familiar criticism, “Where were the auditors?”

Five years on, the entire sorry story is playing yet again to the same tired script.

When the long-anticipated claim was officially commenced, in February 2022, the reaction from KPMG’s leadership was the usual attempted bravado and blame-shifting:  

“We believe this claim is without merit and we will robustly defend the case. Responsibility for the failure of Carillion lies solely with the company’s board and management, who set the strategy and ran the business.”

Now has followed the latest and fully predictable statement of capitulation, from UK CEO John Holt on February 13, 2023 --- which could have been drafted in 2018 and sealed in an envelope marked “Open when needed”: 

“I am pleased that we have been able to resolve this claim. Carillion was an extreme and serious corporate failure, and it is important that we all learn the lessons from its collapse.”     

For want of Mr. Holt’s specification of those “lessons,” let us ask what has been learned –- if anything?

To start, what is not disclosed for the public’s learning is the amount of KPMG’s exit price –- the UK firm using the frequent American tactic of costuming its settlement in a shroud of confidentiality (see the trustees’ claims against KPMG in New Century and against Deloitte in Taylor Bean & Whitaker, and MF Global / PwC).    

Next, depressingly, although there are surely specific lessons available from Carillion about improvements in the technical and complicated reporting, accounting and assurance for large, long-term contracts, none have emerged to inform investors and the capital markets. Not least, that is because the accounting profession has never developed a common forum or other means by which such catastrophes can be put to expert analysis, to be shared for the benefit of all concerned, as is widely done across the business spectrum -- e.g., in aviation safety, structural engineering, medical care, and manufacturing processes.  

One thing we do learn is that the expedient Mr. Holt has reduced by one the number of pending litigation threats against the Big Four that, at their worst, are large enough to be life-threatening. That population now includes, at least, Wirecard in Germany and NMC Health in the UK for EY, and for PwC, Evergrande in China and Americanas in Brazil.

With that small comfort, we also are reminded –- not having needed to learn -– that despite the massive volumes of perfervid critical rhetoric, nothing has been done over the last five years to have any substantive impact on the actual operation of Big Audit, the model by which the Big Four audit all but one of the FTSE 100 and 87% of the FTSE 250.

What has been learned instead is that across the entire body of players, there is a complete lack of will to alter the model:

• The large firms themselves display no discomfort with the current structure of their franchise –- their single gesture having been ready agreement to “operational separation” -- the optically appealing if substantively negligible evolution of expanded disclosure of the organizational and operating distance between their assurance and consulting practices.

• The comprehensive and insightful report and recommendations of Sir Donald Brydon’s “Independent Review into the Quality and Effectiveness of Audit” (December 2019), which recognized the necessity of evolving the assurance model and the qualifications of its professionals, failed to achieve any traction but instead sank without a trace.

• The Financial Reporting Council as the UK’s audit regulator has been shifting its furniture around within what Sir John Kingman described in his December 2018 “Independent Review of the Financial Reporting Council” as its “ramshackle house.” But the prospects that Parliament will actually legislate to re-name and re-configure the FRC as a new Audit, Reporting and Governance Authority –- dead-on-arrival through the years of Boris Johnson and the weeks of Liz Truss –- show no signs of life in the early but distracted and pre-occupied government of Rishi Sunak. Meanwhile as long mooted, Jon Thompson, the FRC’s leader through these fallow years, has chosen to swap one poisoned chalice for another by taking the chair at troubled rail link HS2.

None of this has stopped the whiners, whose petulant voices are heard yet again:

• Annop Rehal of the Haines Watts audit firm (14^th in the UK table -- at £ 105 m in revenue, approximately 2% the size of leaders PwC and Deloitte): the “issue of negligence at the top of the market (is) caused by the lack of ‘real competitors to challenge them’.”

• Gavin Hayes of the Chartered Institute for Internal Auditors: “there is no doubt that there are fundamental issues around a lack of competition in the market.”

For this topic, what has not been learned, or at least is not acknowledged, is the sterility of the discussion on auditor choice and competition, as the advocates for enforced re-structuring of the Big Four’s market dominance have yet to face the reality that the smaller firms lack the capacity, scope of expertise, and risk tolerance to make achievable any such aspirations.

Instead, the complexity of large-company audit and the required range of skills and global presence defy the challenge to carve out for the small firms a portion of such engagements –- either by line of business or by geography, and whether on their own or by forced job-sharing. No assemblage of the firms below the Big Four, singly or in the aggregate, has the necessary capability:

• Performance evaluations by the regulator, and the mix of investigative and enforcement actions involving the smaller UK firms, both caution the prospect of degraded audit quality, should actions be taken to force those firms upon the FTSE-indexed environment.

• A significant reminder regarding audit quality, if needed, is that the case has never been seriously advanced –- much less established –- that “smaller is better.” To the contrary, flares of financial and corporate misfeasance are reported around the globe, all involving the smaller firms: the crypto fiasco of FTX, the Gupta companies in the UK, Lex Greensill’s far-flung structure of companies, and the Adani group in India.

Neither the accounting profession itself nor its hand-wringing critics are heard to advance the difficult if realistic and achievable actions by which to re-engineer a model for large-company assurance that is fit for future purpose. The necessary holistic discussion among all the players awaits.  

 

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Accountants and Their Biases: Human Nature Will Not Be Denied -- Part I

Updating the syllabus and reading list for my graduate-level course this spring in Risk Management and Decision-Making provides a reminder: the members of the accounting profession are just as susceptible as anyone else to the kinds of bias and error that, if avoided, allow for better performance and results. Here the first of a three-part series I am pleased to have written for Caleb Newquist at Gusto:

 

“You can’t expect to improve, if you can’t tell whether you’re good or not.”

Maxim of consultants in decision-making

Trustworthy, high-quality service lies at the heart of the accountants’ claim for public confidence and professional legitimacy. Rigorous standards and high expectations are set for independence of judgment, skepticism, and ethical behavior. 

Yet, to the frustration of the profession, its leaders, and its public critics, undesirable behaviors continue to erupt:

• Large-scale financial failures and scandals that prompt the popular outcry, “Where were the auditors?” –- revealing problems that have been repeated for decades. 
• Corruption of regulatory inspection and oversight through falsification and back-dating of documents and misuse of confidential agency information. 
• Answer-sharing and other cheating on professional examinations.
• Individual violations of trading rules, use of inside information, and breaches of independence rules.  
• Doubts over the profession’s ability to recruit and retain a growing number of properly qualified and skilled personnel, in the context of concerns for academic preparation and workplace environments. 

This despite intense attention and massive investments of time, money, and energy in education, training, messaging from senior leaders, and the development of tools and methodology 

The challenges may seem intractable. But if issues that extend over judgment, skepticism, ethical behavior, and operating priorities are really so hard, are there ways to improve? 

Although the search for simple solutions to complex questions can lead down the road of faulty analysis and wrong answers, a more optimistic perspective is proposed here. Fortunately, we have a half-century of research in the cognitive sciences to open a window into the complexities.

The premise is that accountants share common characteristics with all other fellow humans –- for better or worse. They are not unique or special, differently equipped, or uniquely skilled. They are no less subject to all the influences and pressures that affect and expose the human condition with its frailties and weaknesses.

Which means the news is not all bad. The very opportunities identified in that research have adaptations to the accounting profession’s particular needs. 

Biases, Pressures, and Human Frailty

A rich body of relevant literature sets the stage. A sampling for those interested: 

• The ground-breaking 1974 essay of Daniel Kahneman and Amos Tversky, “Judgment Under Uncertainty: Heuristics and Biases” (Science V. 185)
• Kahneman’s own encyclopedic book, “Thinking, Fast and Slow”(2011)
• Contributors such as Philip Tetlock, “Super-Forecasting: The Art and Science of Prediction” (2015) and Richard Thaler – with Cass Sunstein, “Nudge” (2009 and later editions), and his own “Misbehaving: The Making of Behavioral Economics” (2015)
• A generation of sharp economists, including Steven Levitt and Stephen Dubiner of the University of Chicago, e.g.,”Freakonomics” (2005) and the UK’s Tim Harford, e.g., “The Undercover Economist” (2005) and “How to Make the World Add Up” (2021). 

Greatly simplified, all modern humans carry the legacy of our prehistoric ancestors’ DNA. An early hunter, armed with a spear and hearing the rustling underbrush, faced a critical moment that required an instant reaction: if it were an animal he could kill, the tribe would eat that day, but if a tiger or a wild boar, he was at deadly peril. A stranger emerging from the forest with outstretched hand –- was it in friendship or with a weapon? 

For our ancient predecessors, the fast instincts of “fight or flight” and “friend or foe” were essential to the tribe’s safety and survival, whether against hostile adversaries or vicious predators. Their judgments carried life-or-death consequences for the hunters, although the tribe survived provided they were mostly right, most of the time. 

Those same triggers serve today in many simple cases. When a traffic light changes from green to yellow, no analytic energy goes into a driver’s non-rational “go or no” reaction. Likewise, quick and low-salience consumer choices at a Starbucks counter or a grocery shelf are mostly simple, fast, and non-demanding. 

But these examples show that our DNA has not evolved. The very simplicity of our ancestors’ instinctive reactions means they are maladapted to complex modern challenges. Decisions such as how to allocate an investment portfolio, calculate a reserve provision, where to open a new office, or which candidate to hire are better made with research, deliberation, and consultation.

Like the ancient tribes, today’s society still operates, for better or worse, as programmed for overall survival under normal conditions. This means that decision-making often defaults to oversimplification or resists recognition of the consequential exceptions:

• The very essence of the long-standard auditor’s report, expressed in non-technical terms, conveys a message filled with multiple qualifications — that the client’s information “is generally right, for the most part, over this time period, so far as we can tell within the limits of our work.”
• Likewise, practices and programs for personnel hiring, evaluation, promotion, and management are designed on the assumption that those affected will behave as expected. They act honestly, in good faith, and respond appropriately to guidance and leadership. 

For both of these, the general rules work just fine. Until, under conditions that may seem unusual or unpredictable, they don’t.

The dissonance emerges in both performance and management, because it is the exceptional cases, not the normal and expected ones, that cause the problems (e.g., the white-collar fraudster for whom an audit is an inconvenience to be evaded, the abusive supervisor, the rogue employee).

And that’s when the consequences kick in. Reactions to this bad behavior –- from the profession, its clients, the general public –- can be put in the terms used to discipline unruly children, “when you do right, nobody remembers; when you do wrong, nobody forgets.”

The Ubiquity of Human Bias

The literature has cataloged an entire vocabulary of human bias and error that pervades the accountants’ environment as much as any other area of business or professional services. The irresistible human impulse to simplify complex problems leads to narrowed questions that, by default, are often answered with little time and energy –- and too frequently answered incorrectly. 

Examples from a long list will illustrate.

                                                     In General            In the Profession

The Induction Fallacy (Mistakenly believing that past experience is a complete guide to the future)	It’s only the flu	The CFO has never misled me before
The Planning Fallacy (Over-confidently disregarding the likelihood that unforeseen changes will affect a project’s execution)	The opera house will be finished on time and on budget	Our report is on schedule –- we don’t expect any disruptions
The Anchoring Effect (Over-weighting quantitative information that is visible although not complete or relevant)	“Buy three tires, get fourth free” -  bargain	Receivables  look light–bump of 5% should do it
The Optimism Bias (Ignores evidence inconsistent with desired outcome or narrative)	Our troops will occupy Kiev within two weeks	Client growth 15% last year, so 20% this year is a lock
The Inertia Effect (Continuing past practice, whether or not in a changed environment)       The Bias of Representativeness (Extending an assumption based on limited information)	NASA shuttles launched for years –Challenger good to go     Dressed like that, he surely doesn’t belong here	Scope was fine last year -- SALY     We don’t send recruiters to schools with that ranking

These examples — illustrative and by no means comprehensive -– are common throughout the profession, as they are in society as a whole. And they share a common theme. They all arise out of the natural default to quick, simple, and intuitive reactions inherited from our ancestors that are ill-suited for modern life’s complexities.  

The guidance of the research is best summarized by Richard Thaler (Misbehaving, pp. 355-56): 

"It is time for everyone –- from economists to bureaucrats to teachers to corporate leaders –- to recognize that they live in a world of humans and to adopt the same data-driven approach to their jobs and lives that good scientists use.

"Good leaders must create environments in which employees feel that making evidence-based decisions will always be rewarded, no matter what outcome occurs. The ideal organization encourages everyone to observe, collect data, and speak up."

A word of caution: perfection is not within the grasp of fallible humans with our in-built limitations. “Zero defects” is not achievable, nor does the awareness of our sources of bias assure consistent use of the tools available. But the deliberate aspiration to improve, being the best we can do, has promise.  

Installments to follow will suggest some means to take these thoughts forward to practical application.

 

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Crypto-Land –- The Accountants Discover That It’s Terra Incognita

“Hic Sunt Dragones”

        --Map inscription supposed by medieval cartographers to warn of dangers in uncharted waters

 

Auditors realizing the hazards of fee-paying business? Hell freezing over!!

Perhaps the wintry bomb cyclone of this holiday weekend in the eastern United States signals a convergence of unlikely events.

With the spectacular flame-out of Sam Bankman-Fried’s crypto exchange FTX, the Armanino and Prager Metis firms have been sued over their audits of its US and international operations; Mazars pulled its “proof of reserve” report on Binance and cut ties with other crypto clients; BDO displayed its anxiety over its crypto client work; the Big Four sit in the background with little show of appetite for crypto’s possibly terminal disruption.  

That the crypto sector could be revealed as so toxic as to repel the gate-keepers of the capital markets might once have been beyond imagination –- it long having been an insiders’ wry one-liner that the short wording of a Big Audit engagement letter was, in its entirety, “Will work for food.”

Yet the profession’s retreat from crypto's trackless wilderness suggests two propositions:

• There actually are activities beyond the auditors’ capability to provide assurance within the standards developed since the invention of independent audit in the Victorian era.

• There actually are enterprises whose plans, strategies and operations, and their management competence and ethos, are so deviant as to make them unsuitably risky as clients.

It's scarcely ever been thus. A rare exception arose in my time as in-house counsel at a Big Eight firm –- olden days, very long ago, well before the company that became Enron mutated from a middle-America network of gas pipelines, and before “generally accepted” professional guidance was imposed by Washington functionaries.

(Apologies -- only with both reluctance and prudence am I still obliged to mask identities.)

One of the Big Eight was offered the first-ever audit of a global-scale cartel –- a massively complex, multi-national enterprise with pervasive presence and influence. There was no proposal process or competition –- no questions or limitations –- instead a gigantic potential fee, with no negotiations, and the work was for the taking.

The firm’s senior risk manager for the industry laid down a short, blunt, and non-negotiable refusal. “It can’t be audited. We know there are undiscovered nooks and crannies. We could never penetrate the hiding places and the dark corners. No fee is worth either the political exposure or the catastrophic risk of litigation.” 

Had only that experience been more widely applied –- how might have differed the last decades of “where were the auditors?"

Today, the audit firms that have put crypto work out to the public are already exposed and should expect to pay a price. Some number of their “proof of reserve” and actual audit reports are bound to attract the plaintiffs’ lawyers. Despite the Armanino firm’s position that its digital asset practice generated a mere one percent of its revenues, it is hostage to the “one and done” ligation impact that Enron inflicted on Arthur Andersen.

It would be encouraging to think that the profession is acting on a recognition, however belated –- like the coyote chasing the road-runner over the cliff –- that it’s a long fall to a rocky crash.

Where to from here?

Little enough should be expected from the regulators, who as usual are a day late and a dollar short. That's despite both the bold position of SEC chair Gary Gensler that, for crypto companies’ compliance, “the roadway is getting shorter,” and the speed with which the agencies of American law enforcement swooped down upon SBF, flipping his two top lieutenants and snatching him from the Bahamian authorities to face US-style justice under a $ 250 million bond and electronic monitoring in his parents’ home. There’s a fulsome discussion to be had, as Francine McKenna takes up this week at her substack, The Dig, as to how the regulators were watching the store while fictive crypto entities were allowed to grow like alien invaders into the legitimate capital markets.

Meanwhile in the marketplace itself, both the accounting firms and their clients may be choosing a cleansing re-appraisal of their activities.

It would be cause for cautious optimism if the large firms’ charting of the crypto map led them -- rather than acting as cosmeticians willing to apply lipstick to a pig -- to a simple veto message: “neither crypto nor anybody else has an entitlement to our work, name, or reputation.”   

 

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Tipping Points: The Financial Fragility of the Big Four (Part Two)

“None of us has a clue.”

The late William McDonough, first chairman of the Public Company Accounting Oversight Board in the US, asked in 2005 what the authorities would do in the event of another global accounting network failure.

My guests posts this week on Francine McKenna’s substack, The Dig (here, here and here) –- posted on this blog here, here, and today -- update this question, first examined in 2006 and periodically refreshed:

What size financial hit could a Big Four accounting network withstand and survive, from litigation damages or an enforcement penalty on the scale of the fatal blow that Enron inflicted on Arthur Andersen in 2002?

Applying a behavioral study done in 2006 to the Big Four’s reported data on global and country-level revenues, that evaluated the willingness of Big Four partners in the UK to sacrifice current income to save a firm from a financially ruinous litigation judgment, the results are ominous:    

None of the Big Four accounting networks have the financial resources or organizational stability to survive their largest litigation and law enforcement exposures. If another of the Big Four should fail, the entire model spirals into collapse.

As built out in the first installment, calculations under the 2006 study indicate that litigation-driven tipping points for the Big Four at global level would fall, on optimistic assumptions, well below the level of a firm’s total one-year global profits.

Those limits would however be subject to further erosion based on less optimistic assumptions as to partner behavior, as well as doubts as to the ability of a network to maintain its cohesion and integrity under such challenges, and most especially from a local-country perspective, where the resources to meet a claim measured in the billions (whether dollars, pounds or euros) would be lacking.      

Three topics remain to be covered and addressed here –- the basic issue of the structures of the global networks, the myth that insurance would somehow shelter the Big Four from existential threat, and the disruption that would disintegrate the entire model if another large network suffers the fate that befell Andersen.

The Grim Reality of the Calculations

Bearing on the ominous estimates that emerge from the data just summarized are the structural realities of the Big Four, poorly appreciated, if at all: that their make-up as networks of private partnerships operate with razor-thin levels of capital. That is for three reasons:

• Their major working needs -- employee salaries, space costs, and technology and methodology investments -- are financed out of the short-term cash stream of client-derived revenues.

• The income tax codes of the largest economies are cash-based for partnerships, creating a powerful incentive for the firms to distribute substantially all their current profits out to the partners, speedily and timed to match with their immediate personal tax liabilities.

• There being no alternative need to deploy excess capital or outside investment, under the firms’ current business models, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding tanks.

Above all, it must be remembered that the partners of the large firms are not indentured, nor on-call hostages to the assumptions of the politicians and regulators of the world’s large economies. Put under enough stress, they will act to protect their interests.

Financial Resources –- Credit, Liquidity, and Insurance

The Final Paper of the UK’s Competition & Markets Authority (April 18, 2019 (¶ 7.13)) stated optimistically that:

“Deloitte told us it had access to lines of credit from financial institutions to manage working capital, and it had insurance cover to guard against fines and litigation.”

Not so. As shown by the experience of Andersen’s collapse, neither a firm’s working capital nor its insurance are remotely sufficient, measured against the magnitude of a claim on a life-threatening scale.

As for the credit-worthiness of a network under threat, the unraveling of a firm’s partnership structure, as occurred virtually overnight with Andersen and as was foreseeable under the London Economics study, would prompt an immediate shut-down of lines of credit geared to a firm’s loss of on-going viability.

That effect would be dire because, as the financial statements of the UK firms reveal, their readily available resources are limited, for reasons earlier discussed here. As reflected in the UK firms’ latest filings with Companies House (£ billions):

 

                            Partner Capital                     Cash and equivalents

Deloitte                      £ 256                                       £  608

PwC                              274                                        1,128

EY                                 170                                           385

KPMG                           258                                           465

All very well, for routine operations in normal times, when the firms’ working capital needs are modest because their businesses run on collection of their client receivables. Instead, a comparison with, say, the 2018 settlement by PwC’s US firm of the FDIC’s $ 635 million award of damages relating to Colonial Bank, for $ 335 million, indicates the liquidity peril that a large enforceable judgment or settlement would entail.

As for insurance, the effective absence of the commercial insurance sector from coverage of the large firms at the current and greatly expanded catastrophic levels, and the limited protection of the Big Four’s own self-insurance by way of loss-shifting to the future generations of their younger partners, are underappreciated factors in this entire calculus.

On the commercial side, to use the colorful off-the-record metaphor of an expert industry source, not only is the Big Four’s patchy insurance blanket far too small to cover the liability bed they have chosen to lie in, but also -- as a consequence of large and growing deductions and retentions -- it is thin, frayed and full of holes.

The reasons are readily available, starting with the misalignment of the Big Four’s large-case litigation profile with the insurance industry’s three required suitability conditions, none of which can the auditors satisfy:

• Diversity of claims –- as is the case in large portfolios such as human lives or auto accidents, but absent in a market of only four participants.

• Predictability of occurrence –- again measurable by actuaries if given a suitably large sample size, but absent for the auditors since catastrophic risks exist with the audit of any public company large enough to house potential misfeasance at the multi-billion-dollar level -– history proving that those will erupt with inevitable frequency despite all attempts to achieve the unattainable goal of “zero defects.”

• Quantifiability of exposures –- also without limit under legal regimes allowing claims for damages on a “joint and several” basis up to the total value of a failed corporate enterprise.

It is not good news that the insurance industry’s readiness over past years to support the accountants has long since been outstripped by twenty years of massive escalation in the size of the “worst” cases. Examples start with the $ 67 billion bankruptcy of Enron itself, followed shortly by the revelation in 2004 of the € 20 billion hole in the balance sheet of Parmalat in Italy -– both ahead of the far larger collapses of the institutions that failed across the globe in the financial crisis that began in 2007, and now extend to such failures as Carillion, NMC, Wirecard and Evergrande.

The cyclicality of the commercial insurance market –- subject to finite limits despite the popular assumption that somehow “insurance is always available” -- now finds greater appetite to cover airline crashes and hurricane damage. For the auditors, even today’s ragged capacity would ill-protect against the chilly horrors of the inevitably recurring new litigation nightmares.

Moving on -- above whatever amount of commercial insurance cover may be available, what self-help is there for the Big Four in the build-up of reserves held by their own “captive” insurance operations?

For a start -- at their global level, access to international network resources by a failing national firm would be hostage to the survivability of the cross-border financial commitments of the network’s other members. Again, that optimistic assumption proved illusory in the speedy collapse of Andersen’s global network in 2002 -- appearances of its members’ ostensibly robust and mutually enforceable contractual commitments notwithstanding.

As one of the authors of Andersen’s uniquely cohesive but ultimately fragile worldwide organization put it, “the structure was at best a treaty. And as a treaty, it was only as stable as the continued trust and commitment of all of the separate country practices.”

And moving further on -- whether captive insurer capacity is measured globally or at the local firm level, as put by the London study (p. 93), “insurance capacity is limited by their (partners’) capital,” such that “captive insurance is simply a timing mechanism that smooths the effect of claim payments…” (emphasis added).

In other words, while “captive” operations may qualify as “insurance” within the scope of the industry’s definitions, they effectively operate only as a means of shifting financial contributions between generations of partners. For purposes of tipping point calculations, if partners were called upon to satisfy a massive litigation claim, their readiness and tolerance to re-finance a firm’s future-looking insurance structure, rather than under-writing payments directly to claimants, would only involve the re-direction of the same amount of their individual financial sacrifice.  

That being the case (p. 104), “once the limits provided by the captive have been exhausted, the burden of a large-scale settlement has to be borne by the firm and its partners.” In blunt terms, and as previously discussed, the limiting issue (pp. 104-5) is “the reduction in income that typically partners would be willing to tolerate before jumping ship and endangering the viability of the firm.”

As has been outlined, the readiness of large-firm partners to bear that burden is neither limitless nor satisfactory to assure their firms’ ability to survive. 

The Next Collapse: Not Four to Three, But Four to Zero

Finally, loss of another of the Big Four would throw the entire system into chaos — for lack of auditor choice and readiness among the survivors to stay in an unbearably risky business.

As noted in the first installment here, it cannot be assumed that, just because the surviving Big Four were able to absorb Andersen’s clients back in 2002, along with the staff necessary to serve them, a Four-to-Three scenario is also viable today.

In fact, while Andersen’s failure caused a creaking realignment in which all large companies eventually found a successor auditor from within the surviving Big Four, that quartet today is down to its critical minimum. The uneven concentrations of personnel, market share and industry expertise around the world’s largest economies, the politically imposed restrictions on auditor choice due to outmoded concepts of independence, and the post-Andersen fragility of the large networks combine to show that the current tetrapoly structure is irreducible.

Despite Separation, the “Linchpin” Effect

The 2006 London study for EU Commissioner McGreevy was explicit on the broad global consequences of a failure:

“While the demise of a non-key firm may entail some reputational loss for the network as a whole, and potential problems for the firm’s clients in finding a suitable and available replacement audit firm, it will generally not result in a wide-spread disruption across many capital markets.

“In contrast, the demise of a linchpin firm in a network may imperil the whole network and thus have wider repercussions for capital markets in Europe.”

As is now playing out with the Big Four networks separating their member firms in Russia under the international array of Ukraine-based sanctions, a Big Four network can survive the loss of a member firm in one of the world’s smaller economies, where the scale of client operations would allow a network either to replace personnel and resources or to engage a smaller firm to audit a local subsidiary. The challenge would be altogether different if a Big Four network lost its firm in a country of substantial size –- at the level of the G7 economies and perhaps a handful of others -- one of its critical “linchpins,” on which network survival would crucially depend.

The vision should be clear: a Big Four network that loses its member firm in such a country could neither perform the leading and consolidation work for its global-scale clients based there, nor audit client operations in that country to support consolidated reporting by a large company headquartered elsewhere. Local replacement resources would be scarce, unavailable, or unqualified; conflicts and other limitations would disqualify other Big Four firms, whose appetite to take on a single-country subsidiary would be modest; while smaller firms would lack the qualified personnel and industry expertise to serve global-scale enterprises.

Concisely put, the “linchpin effect” involves a darker aspect of the unique dominance of the Big Four of the audit market for large global companies -- if a Big Four network cannot operate everywhere, it cannot operate anywhere.      

Further to the Attitude of the Regulators

The CMA’s Final Report proceeded on the blithe and erroneous assumption, that the impact of a Big Four failure would be mitigated by movement of partners and clients and the mobility of audits to other firms, including what it calls the “challengers,” or the enforced continuity of its practice while showing symptoms of failure (¶ 7.7). The reasoning does not provide support:

• The collapse of Andersen, given the difference in current conditions presented by a possible Four-to-Three scenario, remains relevant and is to the contrary.

• Nor is there logic to the CMA’s circular position (Update Paper ¶ 3.137 and Final Paper ¶ 3.176) that the Big Audit model would be resilient against a catastrophic failure because of the regulatory requirement for audits. Imposing a legal obligation does not assure the availability of the means to comply. Official impositions are not self-executing. In a “collapse” environment where supply has become constrained, the existence of an official “requirement” for audits would be no more realistic or achievable than a misguided regulation that all audit reports be signed by a left-handed redhead. Collapse on the supply side would instead only leave the entire system out of compliance –- audits not then being available from any source or at any 

The CMA suggests that provisions of some sort would arrest the flight of personnel from a large firm in the process of collapse. Its Final Report (¶ 7.21(d)) contemplated an undefined world in which a regulator would “provide certainty to the markets and transparency to staff to prevent a ‘run’ on a distressed audit practice” (emphasis added).

Experience is to the contrary. The Andersen worldwide structure unraveled at a pace that was neither manageable nor stoppable –- both its management and the authorities were as hapless as all the king’s men and horses confronting the fall of Humpty Dumpty.   

Attempted regulatory constraints on personnel mobility would be of doubtful enforceability in any event, while government-subsidized financial inducements could never overcome the looming threat of personal financial ruin that could be inflicted by an Enron-scale disaster. 

Conclusion

To recap. The calculations offered here have never been disputed—ominous and shockingly small as they are. No other alternative models or estimates have ever been offered. Nor is there any credible claim that a political or regulatory solution is achievable.

Although a public discussion would be illuminating, Big Four financial fragility has been a “third rail” topic. Little wonder that the only available validation is on deep background — reluctantly given at that — which never rises to a position on the record, but suggests that if anything the cited numbers are too large.

One more down, and they all go down. To survive, the stability of the entire wobbly structure of the Big Four rests on the continuing survival of all of them, including the weakest.

Although this picture is neither cheerful nor optimistic, it should not be taken as the counsel of either cynicism or despair. Grave and pressing as are the challenges to the survivability of the Big Audit model, they are within the grasp of the entire community of interested parties.

Denial and evasion do not, however, comprise a strategy for action. That awaits informed good-faith participation on the part of all players, including a readiness to recognize and accommodate the self-interests of each in service to a process of evolution that can only proceed on holistic and comprehensive terms.     

 

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"Tipping Point" Sidebar: Should the Big Four Have Their Own Financial Statements? Should the Cobbler’s Children Have Shoes?

On November 28 I guest-posted on Francine McKenna’s substack, The Dig, the first of two installments to update the inquiry I started back in 2006, as she put it, "to look at the “tipping point” for another Big Four audit firm leaving the playing field -- whether from litigation or a regulatory enforcement action" on the scale that blew up Arthur Andersen in 2002. I posted that piece here yesterday; the second will follow soon.

That conversation is not helped by the limited scope and transparency of the financial information made public by the Big Four themselves. For that, a Sidebar on The Dig today set out the observations that follow here.   

The basic proposition lays out simply, by applying straightforward assumptions about human risk aversion from the behavioral economists to the limited financial information published by the Big Four: It is clear that the international networks are not capable, by structure or financial resources, of surviving a litigation shock on the scale that killed Arthur Andersen. 

Better data would support analysis more refined and granular. Except that the Big Four, for their own reasons, offer only the barest top-line numbers on their own financial performance and condition. For want of completeness, transparency and comparability, the information on which to make like-for-like comparisons and more nuanced assessments is simply not available.

It’s to be emphasized that the Big Four have been allowed to choose the quantity and format of the information they provide to their interested public, operating as they do as assemblages of private local-country partnerships and not as listed companies with required reporting to outside capital providers.

That being said, however, there would be two reasons to consider the desirability of change, either under the interests of the Big Four themselves or as deemed desirable by the profession’s regulators: an improved basis for the on-going discussion of the Big Audit model itself, and the credibility of the profession as it defends against its critics.

The Data Beneath the Fragility Discussion

First is the significance of the issue of financial fragility explored here. If the public debate about the fitness for purpose of the Big Audit model is ever to move beyond the mis-placed notion that the large firms are “too big to fail,” it will be necessary to have in view the data underlying the compelling generalization that they are “too fragile to survive.”

A sampling of the issues that confront a reviewer:

To start, the Big Four use four different reporting periods –- Deloitte uses a May 31 year-end, PwC chooses June 30, it’s July 2 for EY’s 2021 UK filing, and KPMG follows at September 30.

Lines of practice are not consistently described, making comparisons difficult. PwC and KPMG maintain the traditional three-some of Assurance, Advisory, and Tax & Legal. Deloitte breaks itself down to Audit & Assurance, Consulting, Financial Advisory, Risk Advisory and Tax & Legal. EY’s categories are Assurance, Tax (without reference to Legal), Consulting, and Strategy and Transactions.

Practice regions are generally consistent for three regions –- the Americas, Asia-Pacific and EMEA – but without clarification of the regional boundaries. PwC alone provides actual revenue figures by region, and high-lights certain sub-areas, but by percentage changes only and without displaying regional or country revenues by practice line (and, for whatever reasons, PwC’s UK results include its practices in the Middle East). The other three report regional year-on-year results by percentages, but without including the baseline numbers, thus obscuring the ability to observe shifts in practice mix.

Exchange rates are referenced generally, as each network converts its local-country results and reports its top-line figures in US dollars. But none of the networks actually operates under an integrated or cohesive profit-and-loss model for its widely scattered local-country partners, nor do they disclose the pricing mechanisms or transaction amounts for engagements performed on a multi-country basis, making cross-border comparisons of efficiency or profitability invisible to an outsider.

And, to the central theme here of exposure and fragility, the statements are uniformly opaque on:

• The quantification of litigation claims and contingency exposures, reflecting the modus vivendi between the accounting standards-setters and the litigation defense lawyers that has forever permitted a shroud of confidentiality over the uncertainties of publicly predicted litigation outcomes.
• The extent and particulars of available insurance either commercial or “captive.”
• The existence and extent of cross-network undertakings or commitments to support a local firm in financial distress.

The Separate Case for Big Four Financials

The fragility discussion aside, as PCAOB member Steven Harris observed on March 20, 2014, “many find it ironic that auditing firms in the United States…resist providing their own financial statements,” seeing no reason “that the auditing firms that act as gatekeepers to our securities markets should not be as transparent to investors as the companies they audit.”

Harris went on to urge that “the large accounting firms make their audited financial statements available to the public.”

It can be done. Local firms of the large networks in the UK already publish IFRS-based financial statements, audited and reported on by their colleagues (see the readily searchable corporate registry on the UK’s site for Companies House, where those statements are filed).

While unique among the accountancy oversight models, however, the requirements in the UK serve to reinforce the point that the Big Four’s business model, running on client receivables and egg-shell-thin capital, is not designed or robust to withstand a ten-figure litigation shock.

That’s because that information has several gaping holes –- lacking the information noted above regarding litigation claims and contingencies and the extent and availability of resources to enable a local firm’s survival.

As for “Audited” Big Four Statements

It has been done. In the late 1970’s, Arthur Andersen’s global financial statements were audited and reported on by Deloitte’s member firm in the US, then branded Haskins & Sells (whose report for Andersen’s 1977 year-end is below). 

Should the Big Four voluntarily offer such disclosures and assurance? Or should they be required to do so? Over the profession’s long-standing resistance, there could be considerable public education, both from the information to be disclosed, and from that not furnished.

And Who’s to Do It?

Although Arthur Andersen was alone in ever producing independently audited financial statements, its global network fell in 2002 like a house of cards, under the unwillingness of its ex-US firms to support the US firm in its time of Enron-based travail.

Which calls for one irony-tinged observation: the PCAOB and other regulators could require the Big Four to follow the initiative of Andersen’s global reporting from a generation ago, under the PCAOB’s authority over non-US audit firms participating in the audits of public companies filing in the US.

But whereas the Big Four’s UK firms are audited by firms in the next smaller tiers –- who have no significant share of the market for audit services to the world’s largest global companies –- the only auditors having the geographic scope and scale to report on the Big Four’s global networks would be those very four networks themselves.

If put in place, that round-robin of mutual examination and reporting might well be viewed with skepticism by the unremitting critics of the accounting profession who see malign cartel behavior at every turn. Which does not mean it should not be done.

 

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Tipping Points: The Financial Fragility of the Big Four Global Accounting Firms

 

I am pleased to offer a two-part guest post on Francine McKenna’s substack, The Dig, to up-date a project I started in 2006, looking closely at the structural and financial limitations on the ability of the Big Four accounting firms to survive their litigation environment. (Part One here, with a Sidebar and Part Two to come shortly.)

 

"Predictions are difficult. Especially about the future.”

      — Attributed to physicist Niels Bohr, or a Danish proverb

What size financial hit could kill a Big Four accounting network -- litigation damages or an enforcement penalty on the scale of the fatal blow that Enron inflicted on Arthur Andersen?

The question is never raised in polite company. The numbers are so small as to be shocking. And the consequences if ever realized would be nearly too grim to bear.  

Criticism has been intense of Big Audit, for sure -- the model by which the Big Four deliver assurance on the financial statements of the world’s large public companies. But the threshold issue remains unaddressed. Until it is, no meaningful discussion of possible evolution is possible:

Although scarcely acknowledged across the profession[i], the Big Four do not have the financial resources or organizational stability to survive catastrophe-level litigation or law enforcement exposures. If another of the Big Four should fail, the entire model spirals into collapse.

The reason is that, unlike large public companies with their access to outside investor capital, the privately-owned accounting firms must fund their exposures out of partner profits –- meaning existential threats based on the limits inherent in their organization and business models.

 So what is the tipping point –- the size of a financial hit that would be fatal?

After every new revelation of corporate failure or malfeasance, the attitudes of regulators, politicians and the public toward the auditors range from hostility to indifference. But their suggested action list is essentially a blank page. Despite the lack of political or regulatory solutions, the market-place answer matters, and all financial information users should care. Because despite indifference, unease and denial, the loss of another large network would be mean the collapse of the entire Big Audit structure.

I first visited this question in 2006, with up-dates in 2008, 2011, 2015 and 2017, and at length in my book, ”Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books, 2d ed. 2017, pp. 56-64). Over that span the global revenue of the Big Four has grown from some $ 80 billion to approach $ 190 billion in 2022 -– while, as we’ll see, the basic calculations and their implications have not changed.

The unlearned lesson from Andersen’s 2002 collapse is this: in the disruption of the months that followed, all the world’s large companies managed to secure a successor auditor from among the surviving Big Four. But that quartet represents critical mass. There is no serious argument -- under the supply inadequacies of limited and unevenly distributed personnel and expertise, and the regulatory limitations of independence and the narrowed scope of consulting and other ancillary services permissible for audit clients –- that post-collapse auditor replacements would be available. A “Big Three” model is not viable; another collapse would strand significant numbers of the world’s large public companies, leaving them unable to procure the audit opinions required for their securities listings and regulatory compliance, from any source and at any price.

A Model of Behavior, and Its Assumptions

In September 2006, the consulting firm London Economics sent its report to then-EU markets commissioner Charlie McCreevy -– “Study on the Economic Impact of Auditors’ Liability Regimes.” It assessed the threshold of financial pain that would be unsustainable for a Big Four partnership in the United Kingdom, as had happened in the US with Andersen in 2002.

As befit the accounting profession’s long-standing business model –- voluntary private partnerships to which individual accountants commit their energy, reputations and personal capital -- the study was personal. It quantified the limited amount of individual sacrifice beyond which the owner-partners would pursue their personal interests and flee from a business in a death spiral.

Critical numbers of partners would defect, the report concluded, if pushed beyond their individual tolerance -- losing confidence, withdrawing their capital, and voting with their feet. Not forgetting, such self-protective decisions would be taken not in a time of quiet deliberation but -- as those living through Enron will recall all too well -- under the reputational pressure, hostile publicity and litigation exposure of a massively adverse market event.  

Exploring the proposition that partners would put caps on their sacrifice of income to defer or mitigate litigation risk, the report questioned the willingness of Big Four partners to forgo important current portions –- pay packets for 2022 topped by the reported achievement of the partners of Deloitte and PwC in the UK at an average above one million pounds:

• What part of that handsome compensation, which make possible their array of appealing benefits –- cottages in the country, club memberships, fees at elite schools, tables at the charity balls –- would they exchange to reduce, but never entirely avoid, a total loss of position and invested capital?

• With professional mobility and alternative prospects available, in other words, how strongly would they price their incentive for current sacrifice?

The London study in effect brought significant real-world financial stake into the “Oreo cookie” experiments originated at Stanford University in the 1970s. There, with multiple later variants, small children were seen in engaging videos, isolated in a toy room, agonizing whether to eat the single cookie on the table, or to wait fifteen minutes for the researcher to return with a promised second cookie.

Whether cookies or partnership shares, human nature under either perspective was not to be denied. As the behavior of the Andersen partners showed in 2002, there are limits to deferrable gratification.  

The London study examined a range of scenarios and assumptions, including the length of time over which partners might sustain their sacrifice (three to four years), the percentage of annual profit sacrifice that partners might tolerate (15% to 20%), and the impact of a possible 10% reduction in firm income from a negative reputational effect.     

It concluded (p. 105) that critical numbers of partners would bail out, throwing a firm into disintegration, if the alternative was to submit to a financial commitment of individual personal profit reductions extending over three to four years:

“… a sustained income drop in the range of 15% to 20% would result in such a situation. In other words, once the insurance coverage provided by the captive is exhausted, a settlement that would result in such a drop in partners’ income could gravely imperil its survival.”

The Data Underlying the Calculations

 Once the London study’s assumptions were laid out, it only remained to run the numbers –- starting with the global environment.

Publicly available financial information for the Big Four provides context. Their latest reported total global revenue -- for 2022 except for KPMG which reports near the end of the calendar year –- is $ 187 billion. Included here, for later discussion, are figures for the UK, the single large country where the firms are obliged to produce and make public their own audited financial statements.

 

                     Global Revenue  UK Revenue          UK Profit      

                     US $ billions         £ billions             £ millions

     Deloitte        $ 59.3                   £ 4.9                £ 766

     PwC                50.3                      5.0                 1,213

                                       (UK includes Middle East)

     EY                   45.4                      2.75                 596

     KPMG           32.13                      2.43                 436

Some assumptions are necessary, as the firms differ in their reporting conventions and timing, particularly as to what the partners are actually taking home:

• • The mature UK market generates roughly ten percent of Big Four total global revenues, so the UK profitability metric is a reasonable proxy by which to extrapolate to the profits of the global networks.
  • Second, a choice here is to apply to each network’s global revenue the average Big Four profitability in the UK – roughly 20% -- rather than extrapolating from individual UK firms. The effect is to modestly compress the high and low ends of the ranges, while damping the possible effect of particular local conditions in the UK or elsewhere. Either way, the impact is not significant to the gravity of the indicated results.

 Applying the estimated profitability percentage to the firms’ global revenues yields global 2022 profit estimates (rounded US $ billions):

Deloitte - $ 11.9; PwC - $ 10; EY - $ 9.1; KPMG - $ 6.4.

Then using the metrics of the London Economics analysis as applied to the 2022 revenue and estimated profits for the Big Four, estimates can be made of the maximum capacity of a Big Four global network’s partners to absorb and survive a litigation claim at a “break-up” scale.

Once the assumptions are in place, the calculations are a matter of middle-school math. At their most optimistic –- that is, looking for the maximum the partners would give up –- puts the upper limit on their pain tolerance somewhere well below the total amount of a network’s one-year profits.   

It’s well not to squeeze these numbers too hard, for at least two reasons.

First, the model’s results vary widely depending on the assumptions. That is, a collective partner willingness to give up 20% of their annual profits for four years would generate a “litigation pot” roughly twice the size if the sacrifice were 15% for three years and applied to profitability reduced under a 10% reputational hit.

Second, as outlined in a Sidebar to follow shortly in a separate post, more refined analysis is hostage to the limited amount and usefulness of the financial information provided to the capital markets by the Big Four themselves.

The punch line of the exercise, rather, is that any confident prognosis for the survivability of Big Audit is not supportable, for reasons that can now be expanded.

The Broad Run-Up in Litigation Exposures

Non-trivial as these calculations might appear, they must be assessed against the scale of recent litigation history.

In the aftermath of the financial crisis of 2007-2008, the large accounting firms successfully resolved huge litigations with modest settlements, all within their financial tolerance. Examples included KPMG resolving Countrywide for $ 24 million and New Century for $ 45 million, Deloitte settling Washington Mutual for $ 18.5 million, and EY settling private investor claims in Lehman Brothers in 2013 for $ 99 million and wrapping up its exposure in 2015 by agreeing to pay an additional $10 million fine to the New York Attorney General.

That said, multibillion-dollar settlements have become all too common, in claims relating to the financial crisis, the sales of mortgage-backed securities and LIBOR and FOREX rate fixing.

Outside the financial services sector, the list of complex mega-settlements includes:

• The total costs for BP arising out of the 2010 Deepwater Horizon oil well catastrophe, approaching $ 65 billion.

• Volkswagen’s settlements, fines, penalties and customer claims payments exceeding $ 24 billion, relating to its diesel emissions “defeat devices.”

• Investor settlements including Enron ($ 7.2 billion), WorldCom ($ 6.2 billion) and Tyco ($ 3.2 billion).

Those company-paid settlements and government fines were only payable, it must be emphasized, because they could be funded out of the investor-supported balance sheets of the publicly-held corporate defendants. By contrast, the Big Four as networks of private accounting partnerships do not have access to the resources of third-party investor capital.

For the Big Four, making the point with clarity are the settlements by Deloitte in October 2013 and PwC in 2016 of their litigations relating to the white-collar criminal enterprise Taylor Bean & Whitaker Mortgage Corp. and its facilitating financial institution, Colonial Bank.

While those confidential and still undisclosed amounts must have included some level of pain, given that the worst-case exposures exceeded their breakup threshold capability, PwC’s experience in finally settling the FDIC’s case against it relating to Colonial Bank is informative.

The FDIC sought recovery for its $ 2.3 billion bail-out cost in one of the largest bank failures of the financial crisis. An extended non-jury trial on liability ended in December 2017 with a blistering opinion by federal district court judge Barbara Rothstein, followed by a second-phase trial on damages that concluded with a July 2018 award against PwC of $ 625 million.

Compounding the uncertainty of appeal from that large but not fatal amount, PwC’s US firm also faced the FDIC’s pursuit of an additional award of interest –- potentially taking a final award to a life-threatening level. Distressing as it would have been, PwC’s agreement in March 2019 to settle all remaining claims and bring the episode to a close with the FDIC for a little more than half the judge’s award -- $ 335 million – enabled PwC to draw a line under an exposure with otherwise firm-killing implications.  

Extending the Calculations – From Global to Local

Considering the scale of the huge corporate failures of the last two decades, the global estimates here would be grim enough. But they comprise only a first step, as they are hostage to greater partner resistance or erosion of profitability that would reduce the limit of available funding accordingly.

To emphasize, also, they are worldwide numbers, which assume that a Big Four network under deadly threat could maintain its global integrity and the ongoing support of its member firms around the world.

The contrary should be expected, as illustrated by the disintegration of Andersen’s global structure in 2002. Seeing the rapid flight of Andersen’s non-US member firms, cohesion of todays’ international networks under the strain of death-threat litigation cannot be assumed. Tipping point estimates are required at the level of individual firms in their respective countries.

Two preliminary matters:

• The reticence of the authorities today to face the gravity of another Andersen-scale failure, with consequences that can only be described as dire.

• The mortal nature of the litigation blow that felled Andersen, despite the ostensible but illusory protection afforded by its storied financial success and organizational cohesion.

The Attitude of the Authorities, and the Realities

One of the global profession’s more aggressive critics, the Competition & Markets Authority in the UK, issued a brace of papers after the January 2018 collapse of KPMG-audited Carillion. Its Update Paper of December 18, 2018, glanced with delicacy and understatement at the survivability issue, using rather than “fragility” the language of “resilience” (¶ 3.147):

“We have provisionally concluded that failure of one of the large auditors would be very likely to materially worsen the current choice problems in the market and weaken competition.”

The CMA’s skeptical persistence in minimizing the gravity of the risk (¶ 3.285(d)) was plausibly based on simple denial, resistance, and misplaced reliance on the flawed belief that because there had been no further Big Four collapse, post-Enron, there would not be another in the future. 

Facing reality, by comparison, the London Economics study was at least forthright. As examined there (p. 104):

“A mega-scale claim resulting in a large settlement of several hundreds of millions of Euros will be stress on the firm having to settle such a claim.

“At issue, however, is the size of such a settlement that would imperil the existence of a Big-4 network which, in turn, may have significant consequences for the functioning of capital markets.”

Critics of the Big Four have wrung their hands under the mistaken misapprehension that they are “too big to fail” (see the CMA’s Update Paper ¶ 3.149 and the report of April 2, 2019, by the select committee of the department of Business, Energy and Industrial Strategy ¶ 215). They are not. To the contrary, as Andersen’s collapse dramatically demonstrated, the firms with their paper-thin layer of partner capital are not litigation resilient. Faced with potential ten-figure liabilities they are, if anything, too fragile to survive.

 Enron and Andersen –- History’s Lesson from 2002

 The resistance of the critics and commentators to confront the issue of Big Four fragility is based on the disbelief and denial that there could be another collapse.

The skunk at this garden party –- uninvited, unwelcome and malodorous –- is that a single “bad case” outcome would be as deadly today was the destructive impact on Andersen’s US firm of its exposure to Enron.

That attitude of denial, in turn, is based on the persistently erroneous view that Andersen’s disintegration in 2002 was caused by its Enron-related indictment by the US Justice Department.

In fact, the deadly bullet for Andersen was not its indictment, but its overwhelming litigation exposure. The grave implications for today’s remaining Big Four are illustrated by a partial list of pending claims and exposures of the last half-decade: the claim against KPMG by the Carillion receiver in the UK for £ 1.3 billion; claims for £ 2 billion against EY relating to NMC Health, also in the UK; multiple claims against EY by shareholders of Wirecard in Germany relating to € 1.9 billion of non-existent assets; and the initiation of regulatory proceedings in Hong Kong relating to PwC’s audits of Evergrande, the world’s largest and most over-leveraged real estate development complex.

As the catastrophic impact of “black swan” events makes clear, it only takes a single event -- a Damoclean reality for the viability prospects of the Big Four, which today confront litigation claims that on a “worst case” would far exceed available resources.

Calculations using the London Economics study make plain that the Enron-inflicted litigation blow falling on Andersen was mortal even at the global level. In 2001, its worldwide revenue was $ 9.3 billion. Andersen confronted claims by Enron shareholders in the aftermath of its $ 67 billion bankruptcy, who urged that the case would be the first against accountants to reach a billion dollars in actual recovery.

The crippled firm was already dealing with claims involving Baptist Hospital, Waste Management and Sunbeam, and it was about to receive the incoming bombardment of WorldCom and Qwest, among others. A judgment or settlement at the billion-dollar level would at best have left the firm on the cusp of insolvency, an impermissible condition under the profession’s regulatory schemes that require fiscal viability of a practitioner.  

Those who blame Andersen’s death on the Enron indictment miss the point. The firm was like a patient on late-stage life support, already terminally ill and residing in an intensive care unit, who happened to catch a fast-moving infection. Its demise was imminent, and inevitable. By indicting the Andersen firm, the Justice Department only pulled the plug.

Local-Country Separation within the International Networks – A Non-Solution

With its American firm bleeding personnel and clients, and facing ruinous liability exposure over the implosion of its premier Houston client, Andersen’s leaders were unable to negotiate a transaction by which its American practice could be amalgamated in a single transaction with any of the other members of the then Big Five.

The prospect that Andersen’s US practice, as a merger partner or buyout target, might come with the freight of its pending litigation legacy was a burden too great for any of the other firms to take up --­­­­­ either domestically or globally.

That isolation bears on the issue of the large networks’ current country-based fragility, within their larger international networks. That is, on the one hand, global revenues for all the firms –- broadly publicized by their press offices and on their websites –- are many multiples the size of their country practices alone, suggesting at least superficially that fragility and resilience be measured on a global basis.

Experience, however, was to the contrary. When Andersen’s US firm confronted the mortal wound of its Enron exposure, the speed of flight of the non-US network firms, on nearly an overnight basis, displayed their lack of enthusiasm to provide aide and support to their American colleagues and partners.

Nor would the prospect of support from its foreign brethren for a country firm under deadly litigation threat align with the international networks’ careful and precise descriptions of the separation and independence of their respective country practices. The UK-level financial statements published as required by the large firms do not indicate the existence of any supportive cross-border provisions, undertakings, contingencies or related-party relationships –- any of which would be understandably resisted if serving as fodder for plaintiffs’ lawyers eager to extend their grasp over the full breadth of resources of the firms across the larger networks.

The CMA took a dismissive attitude toward a reprise of Andersen’s rapid collapse. Its Final Report approvingly cited (¶ 7.14 fn. 522) an academic’s view that “the Big Four European or US audit networks would aid any equivalent failure in the UK because of the nature of cross-country subsidiaries and entangled business relationships in today’s complex business world.”

That position lacks credibility. It is doubly undercut, both by the absence of public information as to the extent of the Big Four’s cross-border support commitments or available global-level insurance, and by the directly contrary real-world experience at Andersen, with its speedy demise despite the presence of both.

At the Country Level

As a consequence, tipping point calculations must be made on Big Four results and resources, country-by-country.

Start with the Americas -- the United States being still the world’s most hazardous litigation venue. If left to their own resources, as was Andersen’s firm in the United States, breakup numbers for the US practices of the Big Four today, as calculable under the London study’s assumptions, suggest an optimistic upper limit of range from $ 1.5 to $ 3 billion, ranging rapidly downward under a darker set of assumptions.

Perhaps more dispiriting, applying those metrics to the 2022 revenue and profit figures in the UK, the estimated maximum capacity of a Big Four firm in the UK to survive a single large litigation claim (or multiple claims in the same period) fall in an optimistic upper range between £ 600 and £ 900 million.   

To Complete the Picture

Several matters remain to round out the story of the immediate fragility of the large firms: the fundamental challenge of their basic structures, the persistent myth that the availability of insurance somehow shelters the Big Four from existential threat, and the cascade of disruption that would promptly disintegrate the entire model if another large network suffers the fate that befell Arthur Andersen.

These will be taken up in a second installment.

 

[i] An AICPA/NYSSCPA joint brief in 2010 in two cases before the New York State Court of Appeals — Teachers’ Retirement System of Louisiana v. PricewaterhouseCoopers LLP and Kirschner v KPMG, gave passing recognition to the perceived risk:

“The accounting profession is significantly burdened by litigation arising from a widened scope of liability and increasingly aggressive plaintiffs seeking ‘deep pockets’. The biggest threat facing audit firms today is that a single mega-claim or several such civil claims in succession could destroy an audit firm.”