Re:Balance -- Jim Peterson

Critical Audit Matters: Does Anybody Care?

It's always a pleasure to be a guest on Going Concern -- with thanks to Jason, this is up there as of yesterday:

As if the standard auditor’s opinion weren’t already sleep-inducing enough.

 

Standards in the United States now require auditors to identify critical audit matters (CAMs) in their reports on the financial statements of large public companies—things that, in the language of Auditing Standard 3101.11 of the Public Company Accounting Oversight Board, involved “especially challenging, subjective, or complex auditor judgment.” Here the U.S. begins to converge—cannot say “catch up”—with the Key Audit Matters (KAMs) accumulating around the rest of the world under International Auditing Standard 701, issued in 2016.

A wealth of research opportunities is opened. A starting point is the challenge to the data miners, to discern whether this evolution from the traditional one-page “pass/fail” opinion has any actual impact on investor behavior.

Put more bluntly, “Who cares?” So far the proposition is empirically untested, in the U.S. or elsewhere. Two large-company failures, however, point to the contrary.

First was with the complete absence of share price impact when Deloitte’s Amsterdam office included five KAMs in its eight-page report dated Dec. 6, 2016, on the 2016 financial statements of South Africa’s Steinhoff International Holdings NV, the year before the revelation of massive scandal gutted that company’s value and stock price, and led Deloitte on Dec. 13, 2017, to withdraw its report.

The second is of current front-and-center attention in the U.K.—the business cessation on Sept. 23, 2019, of the venerable travel operator Thomas Cook, that country’s most recent large-company collapse.

The blame game started the next day, with the Financial Reporting Council’s indication of interest, promptly followed by the kick-off of its investigation on Oct. 1—another reprise of the perpetual cry, “Where were the auditors?” The press quickly zeroed in on the absence in Ernst & Young LLP’s opinions for 2017 and 2018 of doubts about the company’s “going concern”—not expressed until its review report of May 16, 2019, on the company’s half-year results, which stated (page 33) that “a material uncertainty exists (that) may cast significant doubt on the company’s ability to continue as a going concern.”

But let’s go back—this being about whether investors value available information.

EY’s report dated Nov. 28, 2018, on Thomas Cook’s 2018 financial statements, while not qualified, did add a new and additional KAM to the prior year’s six—an essay of over 450 words specifically labeled “Going concern basis used in preparation of the Annual Report & Accounts” (page 112).

The issue, which EY identified (page 114) as “one of the matters that had greatest impact on the allocation of partner time,” detailed at length the attention by EY itself and the company’s management and directors to the company’s ability to borrow and continue to operate within its financial covenants, which as EY put it (page 112), “remain tight, but pass under management’s severe but plausible scenarios.”

It will be for the FRC’s investigation to assess EY’s compliance with the technical and complex requirement of the professional standards.

However, those keeping track should observe the activity in the company’s stock price. That started with a drop (in pence) from 33.68 on Nov. 29 to 22.72 on Dec. 4, followed by a sharp rise to 34.40 on Dec. 5, all the way to 38.40 on Jan. 4. Not until after that five-week run-up, and five weeks after the KAM disclosures on the company’s going concern, in other words, did its share price begin its terminal decline, which extended steadily all the way to the company’s September collapse.

A scrubbing of the news archives for other possible price-moving information might shed light. Until then, advocates for the proposition that KAMs and CAMs credibly attract serious investor attention must meet the serious question whether and how a sentient reader could have resisted EY’s ominous language, repeated a second time for emphasis, that the company’s survival depended on fulfillment of “severe but plausible scenarios.”

There’s more to the CAM/KAM story—but enough for today.

 

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

This, then:

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

Under these unhappy conditions, barnyard metaphors are irresistible:

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

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

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

 

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Grant Thornton Quits as Auditor of Sports Direct – Why It Matters

“Oh they’ll find some dumb son of a bitch….”

 -- Fire Chief Mike O’Hallorhan (Steve McQueen) to architect Doug Roberts (Paul Newman) – before volunteering to dynamite the water tanks atop the eponymous “Towering Inferno” (1974)

 In an ordinary mid-summer news slump, only yawning disinterest would greet the July 29 news of Grant Thornton’s notice to the UK authorities of its intent to resign as auditor of troubled retailer Sports Direct International plc.

The times are not ordinary; the cauldron of auditor criticism has bubbled since the collapse of Carillion in January 2018. No firm has appeared as a willing successor to Grant Thornton – opening a gap with globally far-reaching implications for the entire Big Audit model.

For context, the parties’ relationship was fraught. The Financial Reporting Council had started an investigation of Grant’s work in 2018, the company’s July 26 release of preliminary results showed performance and stock price in a tail-spin, and the reportedly long-running search for a successor had failed to identify a candidate.

Deflating the posturing confidence of CEO Mike Ashley’s letter in the company’s release, that “we do not believe a firm outside of the Big 4 will potentially be able to cope with such an audit in the future,” none of those firms has taken the bait.

Neither have any of the next tier –- BDO, RSM or Mazars –- unfortunately identified by the Competition & Markets Authority as “challengers.” As for the prospect of a candidate from the still-smaller ranks, the latest Accountancy survey conveys the telling message of scale:

• No firm smaller than Mazars audits a single company in the FTSE 350.
• Of the smaller AIM-100 companies, third-tier firms audit only five, none of which approaches the size of the Sports Direct engagement.

So the day may have arrived when a large public company is unable to secure the services of a qualified auditor. At least three observations are in order:

First, the barren results of Sports Direct’s auditor search reveals the fictive nature of the CMA’s April proposal that all but the largest of the FTSE 350 should be obliged to have “joint auditors,” one of which must be a “challenger” and expected to take up a significant percentage of the actual work.[1]

No criticism of quality, but a quick glance at capacity – if deterred by the scale of the Sports Direct job with its £ 966 thousand fee, “challengers” would even more surely blink at the constraints of expertise, financial resources and risk tolerance involved in taking joint responsibility for the audits of companies larger by several orders of magnitude.

Second, as the Financial Times reported, “under UK rules, the Department for Business has the power to make an appointment if a company cannot appoint an auditor.” The reference is presumably to Section 490 of the Companies Act 2006 – “If a public company fails to appoint an auditor or auditors in accordance with Section 489, the Secretary of State may appoint one or more persons to fill the vacancy.”

That provision aims at a failure of corporate governance, however, not the unavailability of a candidate. At the company level, regulators could hardly force such a result upon a board and management – whose agreement should clearly be essential, the prospect of a hostile and antagonistic auditor presence being unthinkable.

Even less could the FRC presume to force an engagement onto an audit firm reluctant to accept. Professional standards require that the auditor be able and willing to rely on the truthfulness and credibility of evidence and representations from a client and its management – see, e.g., ISA 580 on written representations – making essential the existence and maintenance of mutual trust and confidence.    

Third, the large accounting firms’ vigorously professed dedication to quality has long failed one empirical test. Namely -- no matter how degraded the financial condition or reporting quality or how questionable the character or credibility of management, some pliable audit firm has always been available and willing to engage with any large-company leadership sufficiently sentient to sign an agreement and a retainer check.

So if Sports Direct is indeed left high and dry, it would mark a small but significantly positive step in the profession’s willingness to draw a line for the sake of improved client quality. Putting to rest the behind-doors belief that “Will work for food” is the standard opening message of any audit proposal, that progress should be applauded.

The context of the Sports Direct paralysis being the politically charged evolution of the FRC into the newly constituted Audit Reporting and Governance Authority, it is not hard to envision some serious political arm-twisting of the Big Four, that one of them should relent and take up the poisoned chalice. For the firms, the necessity to resist that pressure would put at stake their very professional integrity.

Whatever political and regulatory energy may survive the Halloween deadline for a Brexit resolution, it is within optimistic expectations that the “purpose of audit” review now in process under the leadership of Sir Donald Brydon will bring clarity of analysis and reasonableness of vision to the challenges of evolving today’s Big Audit model to one fit for future purpose.

Figuring in that project, Sports Direct may well be left orphaned, to bear the consequences of its regulatory non-compliance. If so, that would be a tentative but real demonstration of the gravity of the issues requiring resolution in bringing about the necessary changes.

 

[1] For a detailed exploration of the various official proposals pending in the UK, please see my new book – “DOA: Can Big Audit Survive the UK Regulators?” – available through Amazon in paperback and e-reader formats.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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What Price Wrong-Doing? Sanctions Against KPMG Are Complicated

It's always a pleasure to be a guest at Going Concern -- where the post below appears as of this morning, looking at two front-burner topics this summer in the US and the UK. For a detailed review of the threatening and volatile environment in the UK, where official actions threaten the stability of the Big Four business model and the viability of their franchise to audit large public companies, I invite you to my new book, available on Amazon in paperback and e-reader formats -- "DOA: Can Big Audit Survive the UK Regulators?

“Sell in May and go away” was an investors’ adage invoked as vacation strategy in a more genteel era. Returns in the summer were said to lag the rest of the year—and in any event, that’s how brokers justified their holiday cottages on the eastern seaboard.

This year the maxim has twice failed my attempt to stay off the grid. Most visibly, the SEC on June 17 ordered a $50 million fine against KPMG LLP; the penalty was a two-fer: both a complement to the criminal proceedings against senior personnel of the firm and the PCAOB for the theft and misuse of agency inspection information, and also for the firm’s gaming of internal training and tests, including those done under prior orders of the SEC itself.

Also there is the inquiry in the U.K. into the “purpose of audits,” led by former London Stock Exchange chair Sir Donald Brydon, under a charge from Greg Clark, Secretary of State for Business, Energy and Industrial Strategy—latest in a series of official proceedings involving the Big Audit model, inspired by a series of scandals originating with the January 2018 collapse of the giant public contracting enterprise Carillion.

Sir Donald’s convocation of two diverse advisory groups, and his upbeat Twitter note that his Call for Views in April elicited 110 responses, provide optimism that the project will not only look at the expectations of the capital markets for an audit model fit for modern purpose, but also assess the realities, weaknesses, and challenges in the existing market dominance of the Big 4.

Uncertainties around KPMG’s punishment connect the two. The link is the under-appreciated fragility of the Big 4—the shockingly low ceiling on the financial capacity of the firms to survive a fine or judgment on the scale that Enron inflicted on Arthur Andersen, because another collapse would put at risk the entire model.

A $50 million fine against KPMG is not itself of that magnitude. Spread among the roughly 2,200 partners of the U.S. firm, with its 2018 revenue on the order of $9 billion, the bearable impact is about $23,000 per partner. (The LLP does not disclose profits per partner, but a comparison with the disclosed 2018 partner profits of the KPMG network’s firm in the U.K.—£601,000, or about $765,000, is probably reasonable.)

Skepticism about the size of the hammer wielded by the SEC has come from well-recognized critics: in the U.S., Jason Bramwell at Going Concern, Matt Kelly at Radical Compliance, Francine McKenna at MarketWatch; in the U.K., twittering academics @premsikka and @atulshah among others.

Which is not unfair. A fine of even $100 million would not raise the individual impact above $50,000 each for the average KPMG LLP partner.

But the critics’ argument for a fine of $1 billion, nearing $500,000 per partner, would be another matter. That would be seriously painful and, if doubled, would raise the existential challenge that insecure partners would swallow their loyalty, withdraw their capital, and vote with their feet—throwing the firm and its entire global network into an Andersen-like death spiral.

Theoreticians and policy-makers concerned with crimes and punishments have agonized over the complexities: What level of sanctions properly balances society’s desire for deterrence with the appropriate pain on a wrong-doer? How well is justice served, where collateral concerns—here, the survival of the Big Audit model itself—put a practical ceiling on the ability to punish?

If the problems with money fines are intractable, what other tools are available? The SEC’s June 17 order (paragraphs 65 to 82) includes a basket of multiyear reviews, reports and undertakings by leadership of KPMG LLP, and requires the engagement of an independent consultant.

Enough to satisfy the critics? If those impositions are too light to be credible, suppose creation of an office of the CEO, with C-suite presence of outsiders on a day-to-day supervisory basis.

The idea that senior management be supplanted by outside leadership has been advanced at least twice—first in 2002, as Arthur Andersen lurched to its collapse, with the non-starting notion that the eminent Paul Volcker should step in, and again in 2008 as a proposal of the Advisory Committee on the Auditing Profession convened by Treasury Secretary Henry Paulson.

Both met understandable ridicule and rejection. The powers of a newly-arrived corporate CEO to hose the stables might be effective—wholesale firings and reorganizations would be well within scope. Not so, as Andersen’s experience demonstrated, where a partnership’s viability depends on retention of the skills, votes, and mutuality of trust and confidence among a committed collection of partners.

“Solutions” either facile or intemperate being unhelpful, here are offered two desires:

First, that for the sake of their credibility, the critics should be obliged to annotate their harsh rhetoric with constructive proposals by which to replace the current Big Audit model, which the draconian penalties they urge would threaten to destroy.

Second, that Sir Donald Brydon’s review will have sufficient breadth to embrace the entire array of inter-connected issues, including the survivability of the Big 4 model for privately provided large-company audits.

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

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

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

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

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

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

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

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

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

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

 

Failure Study: Can Auditors Get Better?

“How can you hope to improve, if you can’t tell whether you’re good or not?”

My article, Failure Study: A Needed Addition to the Accounting Toolkit, is just out in the March edition of the CPA Journal, published by the New York State Society of CPAs.

With my thanks to editor-in-chief Rick Kravitz and his team, a direct link is here. And because not all readers here would have the Journal on their lists, it’s my pleasure to offer it in PDF below.

Here's the theme: the accounting profession lacks a forum by which to examine its instances of questionable performance, for lessons to be learned and opportunities to improve.

While “failure study” is an article of faith, deeply embedded and pursued in many other sectors – medical care, engineering, aviation safety and operations, manufacturing processes – the accounting profession has found reasons, if not justifications, not to join.    

For context, recent months have seen refreshed examples, circling the globe with intensified criticism, that repeat the invariable question – “Where were the auditors”:

• The January 2018 collapse of contracting giant Carillion in the United Kingdom, arousing regulators, politicians and media alike.
• Money laundering through the Estonian branch of Danske Bank.
• Falsified transactions at South Africa–based Steinhoff.
• The looting of Malaysia’s 1MDB fund.
• Litigation in Japan by shareholders of Toshiba.
• In the US, criminal proceedings relating to information theft and mis-use by PCAOB employees and senior personnel at KPMG, and PwC’s settlement of the FDIC’s judgment relating to Colonial Bank.

As spelled out in the Journal article, the structure and remit of an effective failure study forum are available, for the value it could bring to an assurance model now under challenges – from these examples and any number of others -- of trustworthiness, stability and fitness for purpose.

The conceded difficulty would be one of implementation, involving all the participants in the Big Audit model. Nothing less would be required than broad cooperation and buy-in -- from issuers of financial information, users in the capital markets, the accounting firms providing assurance, standard setters, legislators, and regulators and law enforcement agencies.

Discussion and debate – reactions and comments – are invited and welcome.

Download CPAJFailureStudy

 

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Facing the British Politicians – A Strategy for the Big Four

The Big Four accounting firms, under intense pressure in London and with their business model at risk, have at most limited influence. A possible strategy in the face of political and regulatory animosity lies in the folk tale found in many cultures -- the clever rabbit, who evades his dire fate at the hands of the voracious fox by pleading not to be thrown into the briar patch.

It would seem so, watching the televised January 30 session of Parliament’s Business, Energy and Industrial Strategy Committee, on “The Future of Audit.”

The Committee focused on the recommendations in the market study by the Competition & Markets Authority and the review led by Sir John Kingman. While other ideas were tabled, the two headline prospects seem to be: (i) mandatory “joint auditors,” for all but the largest of the FTSE 350 companies, to include the “challengers” – firms below the size of the Big Four – or (ii) compelled reduction of the Big Four’s dominant 97% market share.

Passed over here for possible later attention is the genial shared attitude toward the Kingman recommendations to replace and re-engineer the Financial Reporting Council (see the hearing broadcast at 10.51, 11.04). The track record of the profession’s regulators considered – and images of the crew re-arranging deck chairs on the Titanic are difficult to resist -- supplanting one bureaucratic structure with another appeared not important enough to be worth resisting.

With the Committee’s eager desire to “get on with it” (see 10.59, 11.59), either of these options would have fundamental impact. So it is worth a comparison, from the perspective of the firms both large and smaller.

Witnesses from the Big Four all expressed opposition to a regime of mandatory joint audits, citing:

• The absence of evidence that participation of a second audit firm actually achieves an improvement in audit quality (11.08, 11.29).
• The absence of joint auditor value as shown by the lack of uptake in markets where it is an available but unused option (11.29).
• The record of joint audits in France, the single country where local politics creates particular conditions in the legal and governance regimes (10.50, 11.29), and where it has not opened that market beyond the limited share of a single challenger firm (11.29).

In addition, as a risk issue for Big Four incumbents but also a Trojan Horse for the challengers expected to act jointly, the prospect cannot be avoided of added cost, complexity and performance quality risk (10.46, 11.11). Two reasons:

• First, while the challengers asserted their professional capability to perform, they admitted to significant issues with the expansion to scale of their personnel and expertise capacity (10.01, 10.48).
• Second, under the CMA’s proposal the challengers would not only take on significant basic audit work. They would also conclude and opine separately on an issuer’s top-level financial statement consolidation (see 10.04) – a risk with particular liability implications for audit opinions issued into the litigation-prone Anglo securities markets, the US in particular.

For purposes here and absent satisfactory research either way, the challengers’ position on capability may be taken on faith – although the UK record-setting judgment of £ 21 million awarded on January 31 against Grant Thornton over its audits of Assetco, along with the furor over Grant client Patisserie Valerie’s apparent £ 40 million in falsifications and irregularities, serve the point that audit performance by the challengers is not demonstrably superior to that of the Big Four.

With the steely cynicism expressed by Rachel Reeves as Committee chair, on the expectation of fraud detection in the audit of “a shop that sells tea and cakes” (10.32), the Committee did introduce a new cliché into the never-ending antagonism between auditors and information users.  

As noted, and as against the unanimity of Big Four opposition to mandatory joint audits, the large firms’ attitude toward market caps and the surrender of some significant portion of their large-company clients seemed almost benign (11.07-.08, 11.11, 11.28) – for which there are also several reasons:

First, a share reduction from 97% to around 75% might contemplate the shifting of perhaps 60 to 70 engagements over several years time -- each of the Big Four giving up some 15 to 20 jobs.

That’s a modest enough number, especially since the specifics would involve the complex gamesmanship of a four-way dialog among (i) an incumbent Big Four auditor; (ii) the companies identified as candidates, whose audit committees would have to be satisfied with the adequacy of a replacement; (iii) one or more tendering challengers, who would have to demonstrate both the ability to present a satisfactory tender in the first place and execution capability and capacity in the event of success; and (iv) the newly-constituted agency supplanting the current FRC, which itself would be required to ramp up to evaluate and approve the entire process (see 11.09, 11.12).

From the Big Four perspective, the unlikelihood that such a multi-party exercise could be launched and effectively operational within a time span measured in less than a generation would make participation an option with modest risk and more than adequate opportunities to manage to advantage.

All the more, as the Committee seemed to use a metric for selected movement based on head-count (11.07, 11.11), with the consequence that the companies selected for shifting would concentrate at the bottom end of the FTSE 350 scale.

Such a metric might raise an issue of optics and political acceptability, as the companies comprising the bottom quintile of the index by size account for only about 2.5% of its total £ 2.45 trillion in market capitalization. On the other hand, the question is daunting whether the challenger firms could, over any reasonable time span, ever build the capacity or assume the risk profile to take on the company population necessary to represent 20% of the FTSE 350 by capitalization.

To summarize the risk evaluation of a Big Four firm as between the options: A market cap would mean shedding 100% of the liability and exposure involved in the audits of a score or so of smaller-company engagements – with those devolved to challengers willing to accept that start-up issues in the first years of new engagements are well-recognized for maximum risk of failure. Offered a choice, for the Big Four, that risk-mitigating option would seem preferred over the intrusion into their entire portfolios of mandated joint auditors.

Why a challenger firm would want such a supposedly positive opportunity is another matter. Competing each year for the chance to take on an additional half dozen new jobs apiece – all of them larger than anything presently done – with the “early years” challenges and the prospect that any single blow-up on the scale of a Patisserie Valerie could be fatal to their limited financial resources – leadership would need to be bold indeed.

Forced to choose between unattractive options, in short, the Big Four’s strategy to support market caps would adapt from the animal kingdom the rabbit’s view of the briar patch.

Different for the challengers, for whom perhaps better suited is the supposed advice to her daughter by the wife of Prime Minister Stanley Baldwin, on managing a young suitor’s predatory advances. Drawing on her own experience, Lucy Baldwin is quoted:

“Just close your eyes and think of England.”

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

 

 

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

“Join a poker game not knowing who the patsy is – then you’re the patsy.”

            -- Gamblers’ maxim

The UK’s Competition & Markets Authority delivered a sack of coal as its holiday gift to the capital markets -- its December 18 “Statutory Audit Services Market Study”. Especially dubious is its proposal (¶¶ 4.26 et seq.) to require joint audits of the country’s large public companies.

Now 97% audited by the Big Four – Deloitte, EY, KPMG and PwC – the FTSE index companies would instead be expected to welcome the imposed addition of firms from down the league table.

If there is any benefit in dividing responsibility between audit firms of any size, for either competition or audit quality, the evidence lies somewhere between scantily ambiguous and seriously negative (see here from October 24, and the egregious experiences of Equity Funding in the 1970s, Parmalat three decades later, and Danske Bank today).

A more practical issue is one of supply. The CMA assumes with Panglossian naïveté that what it optimistically calls the “challenger” firms are eagerly massing to seize its proposed opportunity. Instead, from the perspective of a smaller firm’s tolerance for Risk or Strategy, images like “Trojan horse” or “poisoned chalice” might have more resonance.

For context, a look at the firms surveyed by the CMA -- measuring by audit revenue, since the CMA would also force the firms to ring-fence their audit practices, via an "operational split" with “separate management, accounts and remuneration,” and also giving effect to the pending merger by which UK firms of Moore Stephens are to join BDO:

 

    PwC Deloitte EY  KPMG BDO Grants Mazars RSM

   1,334  1,027    677   590      235    157       82       78 

Accepting the current impracticality of deploying the smaller firms on the scale of the FTSE 100, the CMA would start with the FTSE 250 – for which, examples of the devilish details lurking in the ambitious remit offered a smaller firm:

• “Undertake a significant part of the overall audit procedure, from both a quantitative and a qualitative point of view,” escalating upwards from 10% over time (¶¶ 4.34-4.35).
• “Regular changes in the allocation of audit procedures between the joint auditors over the years” (¶ 4.34).
• With both auditors having joint liability, “consolidated accounts would be audited by both joint auditors, and then cross-reviewed” (¶ 4.38).

Put mildly, such a program would challenge the challengers. The reasons start with the costs and logistics of choosing to play at all, as confirmed by both this spring’s announcement by Grant Thornton of its withdrawal from the punishing economics of the tendering carousel, and BDO’s modest forswearing of “big table” ambitions.

To achieve joint auditor coverage of the FTSE 250, the necessary ramp-up would likely span the ten-year timetable of the Financial Reporting Council’s re-tendering requirements -- meaning competitive tenders for some 25 new engagements each year. Apportioning success across the smaller firms by their current size would mean perhaps eight new awards each year to BDO/MS and Grant Thornton, and some four apiece for RSM and Mazars.[1]

Not only would this tender process be demanding, disruptive and expensive. But because sole-sourced tender approvals would hardly suit the CMA’s claim for ideologically virtuous competitiveness, multiple submissions for each tender would be expected. The result: a firm’s “win rate” could not be assumed to be more than one out of every two or three attempts.

So challengers would be hit with four separate investment obligations of time, energy and financial and professional resources:  

• To obtain and deploy the personnel and expertise needed to understand, scope and submit for competitive tenders in the first place.
• To eat the costs of securing no more than half to one-third of the tenders submitted.
• Actually to staff up and perform a significant body of audit work, for engagements when and as won, that would both increase in complexity and rotate in subject, substance and locations each year.
• And to suffer the flat-out duplication of both cost and hazard involved in two-firm responsibility for the audits of client consolidations.

Finally, after all this effort, would lurk the ultimate threat of litigation exposure -- at amounts that would threaten a firm with bankruptcy and disintegration based on legal fees alone, much less the imposition of serious fines or judgments.

That’s because, under the UK’s liability regime – unlikely to change for lack of either popular support or legislative energy – legal exposure would be “joint and several” for 100% of any auditor failure to satisfy the “expectations gap” – a measure also applicable in the American securities market where significant numbers of the FTSE 250 are present and exposed.

For over a decade I have calculated financial “tipping points” -- liability amounts that would be fatal to an audit firm’s lightly capitalized partnership structure. Those estimates are ominous enough for the Big Four -- at country level, in the $ 1 to $ 3 billion range; for the next tier – observing that the audit revenues of RSM and Mazars are about six percent of leader PwC’s -- their disintegration tolerance level would be on a similar scale.

That a smaller firm can face such a deathblow need only reference the case of Clifton Allen in the US – auditor of the city of Dixon Illinois, and dragged to the precipice before settling its exposure to the notorious Rita Crundwell’s plundering of $ 53 million from the city coffers under the noses of its leaders and its auditors.  

To conclude: although gourmands may view foie gras as a delicacy, hardly ever does anyone ask the views of the geese. In sensible decision-making reality, the gorging required for all of the mid-tier firms, to fatten themselves at the CMA’s risky and otiose behest, would be hazardous to their health.

 

[1] Two related side issues, because the CMA includes no supply-side margin for error. Not even the CMA itself gives credence to meaningful participation by firms at a “third-tier” level, while even a single drop-out based on litigation impact or business risk would reduce the four-firm roster of "challengers" below critical mass.  

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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Re-Engineering Big Audit -- Cautions From The Supply Side

Judge: “I’ve listened to you for an hour, and I’m none the wiser.”

Barrister: “None the wiser, perhaps, my lord, but certainly better informed.”

           -- F.E. Smith, First Earl of Birkenhead (1872-1930)

This series continues, on the proposals floated in London that, as claimed by the proponents, would address issues of quality and competition in the Big Audit market.

The advocacy is vigorous: papers released by the profession’s regulator, the FRC and the nation’s competition authority, the CMA; and a position by a UK government ministry. Proposals include splitting up the Big Four, forcing them to divest their non-audit services, mandating joint appointments, and even turning over the auditor evaluation and selection process to official authority, with the declared intent to reduce the Big Four’s dominant market share of the FTSE 350 down to 80% or even 60%.

Leaders of both KPMG and Deloitte have taken positions that no ancillary work be done for audit clients except as part of the audit. Will such a pre-emptive shift persuade the aggressive critics, or merely be chum for the sharks? Time will tell, and soon enough; although the Financial Reporting Council as the UK's audit regulator is effectively sidelined in the discussion, with the announced departure of its chief executive Stephen Haddrill, the inquiries fast-tracked by Andrew Tyrie at the CMA and City grandee Sir John Kingman are sprinting to their intended yearend conclusions.

Postings here on September 25 and October 8, October 16 and October 24 aimed to bring reality to bear, starting with a graphic illustration of the actual details of the market. With what measure of success? Only to say that the longer the official hand wringing continues, uninformed by attention to the hard facts, the more likely will be the deep and fundamentally harmful effects.

Here a step back, to consider the supply-side.

For context, the 2018 results: First out of the gate was EY on September 13, with global revenue of $ 34.8 billion, Assurance growth of 4.4%, and Advisory and Transactions chalking up 10.1% and 13.9%. Deloitte followed on September 18, muscling its leading position up to a global $ 43.2 billion, with Consulting growing at 15.7% and Audit at 7.7%. On October 1, PwC kept its second spot at a global $ 41.3 billion, with its Audit growing at 4% and Advisory at 10%. KPMG, typically reporting near the year-end, is expected to remain a trailing fourth.

To visualize how completely the Big Four's massive numbers overwhelm the rest, here from the International Accounting Bulletin are the 23 largest networks by 2017 revenues ($ millions):

Deloitte	38,800	Grants	5,005	Kreston	2,262	RussellBfd	460
PwC	37,680	Crowe	3,813	Mazars	1,680	MGI	429
EY	31,404	Nexia	3,620	PKF Int	1,298	ECOVIS	375
KPMG	26,400	BakerTilly	3,400	UHY	540	ShWing	361
BDO	8,133	MooreSte	2,909	SFAI	524	EC&CS	207
RSM	5,095	HLB Int	2,369	PanChi	464

The trend carries forward for another year -- audit practices continuing to lag consulting, with revenues essentially stagnant save for the effects of fee increases and perhaps uplifts for incremental expansion of work done to issue the standard “pass/fail” report.

That cannot be a surprise. In the FTSE 350 sector where the regulators’ agita is burbling, both the sector itself and movement of clients between auditors are basically zero-sum. That is, since by definition the number of engagements is fixed and constant, acquisition of a FTSE 350 engagement by one firm – Big Four or otherwise -- necessarily means its loss by one of the Big Four.

Where then, would a small firm go, as either a successfully tendering newcomer or as beneficiary of government-coerced market re-allocation, to acquire the necessary qualifications? Neither a losing incumbent Big Four firm nor its experienced although now-redundant engagement team would have any reason to find a migration attractive.

Instead, a larger firm will re-deploy its personnel, through the inevitable effects of retirements, relocations, out-placement and other turnover. Even if a Big Four team could be enticed to move – although with what inducements to “trade down” would take some persuasion – a shifting of bodies, desks and telephone numbers would have no impact on the level of performance quality or actual quantum of competition.

Nor could the newly challenged small firm expect to raid elsewhere. There would be no obvious incentive for team leaders at the other large firms to give up the stability and perquisites of a secure Big Four position, to be lured into the disruption and uncertainty of a supplicant seeking a seat at the big table.

Neither are experienced Big Four partners, capable of leading complex large-company engagements, sitting idly in wait to be poached. The next generation of once and future expertise is developed over a full cycle – staff to senior to manager to partner – with massive efforts of time, training and experience, and through a winnowing process against demanding standards.

The FRC, if it survives, or any other agency that would presume to judge and compare the qualifications of smaller firms to assume the audit of a company of global scale should, then, be able and ready to pose these questions early in its evaluations:

• “As you have never audited a company of this size in this sector, what expertise do you actually have in place today, by which to understand what your staffing and other needs would be?”

• “Assuming you can answer that question, from what sources do you expect to grow, hire or otherwise obtain the personnel and expertise that this engagement will require and that you presently lack?”

Regulators hubristic enough to believe themselves competent to conduct that inquiry would well consider the Dunning-Kruger effect -- that the lower one’s qualifications in an area demanding expertise, the less able to judge both one’s own ability and that of those being assessed, and the more likely are serious errors based on misplaced over-confidence.

Better, they would heed 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 Big Four failure, he said:

            “None of us has a clue.”

 

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Up-Date from the UK Audit Regulator: The FRC’s Skipper Jumps Ship

Stephen Haddrill, beleaguered chief executive of the Financial Reporting Council, the audit regulator in the United Kingdom, is reportedly to debark by the end of the year.

No surprise. Haddrill has been a marked man since early this year, his agency targeted in Parliament as “toothless”, “useless” and “ineffective” amid an outbreak of outrage over the collapse of the construction group Carillion, the massive hole revealed in the pension fund of BhS with its collapse post-sale for £ 1 by Sir Philip Green, and its own endless inquiry into HBOS.

A raging tempest of official inquiries into the provision of financial statement assurance for large public companies extends to both the market-dominating position of the Big Four – Deloitte, EY, KPMG and PwC – who collectively audit all of the FTSE 100 and 97% of the FTSE 350, and the structure and efficacy of their oversight.

“Thrown under the bus” would be apt.

Or – to provide historical perspective for those curious about the inevitable back-story -- consider that the modern audit function was invented in the Victorian era, while ships of Her Majesty’s navy were enforcing Pax Britannica by flying the Union Jack around the globe. To invoke the nautical metaphors:

• Is Haddrill making his jump ahead of an inevitable walk of the plank or swing from a yardarm?
• Is he merely the first rodent to debark a leaky and sinking ship?
• Are the FRC’s own proposed “solutions” yet further exercises in re-arranging the Titanic’s deck chairs?
• Or is Haddrill just an earnest but hapless cabin boy, while a mess of squabbling brass-hats blithely sail toward the rocks while resolutely steering by the wake?

If none of these will serve, perhaps the sardonic observation of Voltaire’s Pangloss, that it may be necessary to shoot the occasional admiral, “Pour encourager les autres.”

That is because the degree of justifiable criticism and public distress over the fitness for purpose of the current Big Audit model remains unmatched by clear-eyed awareness of the lack of either achievability or beneficial impact on the perceived issues.

That is, concerns over market competition, concentration and audit quality have elicited a “wish list” that includes splitting up the Big Four, forcing them to divest their non-audit services, mandating joint appointments, turning over the auditor evaluation and selection process to official authority, and even forcing reduction of the Big Four’s dominant market share.

But as examined here in an on-going series begun last month, there is nothing good that can come of any of these, but only disruptive and ineffective adverse consequences. Nor will poor Stephen Haddrill’s rowing away into the sunset have any good effect at all.

 

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Regulators' Re-Work of Big Audit? – “Joint Audit” Is Another Non-Starter

Today’s topic is “joint auditors for large companies” – continuing a series from September 25 through October 8 and October 16, on the issues involving Big Audit that confront the regulators and politicians in the United Kingdom who seem determined to impose disruptive change.

Along with cultivation of smaller firm participation, proposals reflected in papers issued by the Financial Reporting Council and the Competition & Markets Authority and political pronouncements from both parties include break-up of the Big Four, forced separation of their non-audit services, auditor appointment by government authority, and voluntary reduction of their 97% share of the FTSE 350 market.

The optimistic case that encouraging or requiring joint audits might beneficially affect audit quality or increase the competitive access and capability of smaller firms to perform large engagements is found, e.g., in the CMA’s paper, ¶¶ 4.18-.22. There are three challenges -- each distinct and sufficient: capacity, quality and risk tolerance.

Capacity

On the ability of the smaller firms to gain market share, to affect competition and auditor choice, look to the French market, where joint auditors are required. Companies in the CAC 40, France’s large-company index, primarily choose two Big Four firms. The only smaller firm with any index-level participation is Mazars – fifth ranked in France, ninth in the UK and 14th globally. Its 2017 global revenue of $ 1.68 billion is approximately seven percent of the average revenue of the Big Four.

At that size and scope, Mazars has little reasonable prospect of taking on a FTSE 350 engagement, much less one in the FTSE 100. However beneficial its experience in France, Mazars has not grown the capability to obtain and share a joint audit with any of its smaller brethren, whose limitations would if anything be more acute.

On the capacity issue, in short, the French market experience has spoken with eloquence.

Quality

The proposition that joint audit contributes positively to audit quality suffers the familiar challenge of a small sample size and a lack of empirical support. While a research project awaits the attention of a curious scholar, historical experience supports the opposite.

Most recently, in the years under scrutiny for the € 200 billion laundered without discovery or disclosure through the Estonian branch of Danske Bank, the bank’s annual reports show that its audit was done jointly by Grants and KPMG for 2007-2010 and PwC and KPMG for 2011, before one-firm takeover by KPMG for 2012 and 2103, EY for 2014 and finally Deloitte for 2015 onwards.

Five years of joint audits, in short, were no more effective by way of detection or prevention than performance by a single firm.

As a brief sidebar on a related subject, the rotation at Danske through five different audit delivery models over nine years does no favor to the “fresh eyes benefit” urged by the proponents of frequent and mandatory auditor replacement.

There is history. Back in 2003, Deloitte and Grants had shared the audit of Italian dairy conglomerate Parmalat. Disclosure of a € 20 billion hole in its accounts revealed the mechanism: bogus contracts housed in an account labeled the “buco nero” (“black hole”) – colorfully evocative although insufficient to entice preventive inquiry by either or both.

As a precursor, the great Ponzi scheme of the 1970s run at Los Angeles-based Equity Funding involved the separation of audit responsibility between Haskins & Sells, as it was then branded in the US, and a small firm recently joining the US operation of what is now BDO. At the heart of the criminal scheme was concealment from both firms of the creation of whole ledgers of non-existent holders of fictitious life insurance policies.

To summarize, division and sharing of audit responsibility with its challenges of communication and administration brings the risk of cracks through which problems and manipulations may fall undetected.

Risk Tolerance

To conclude, the professional auditing standards permit the division of work between two or more firms (see the PCAOB’s AS 1205 in the US, and ISA 600 as widely adopted elsewhere).

In practice, the principal auditor judges whether and how to make reference to the other auditor (ISA 600.11 and AS 1205.04-.09). Either way, while the choice has implications for the level of responsibility assumed by the other auditor, the principal auditor retains responsibility for the entire scope of its own work – including the adequacy of its reliance and delegated decision-making.

There is the bind, in jurisdictions such as the US where “joint and several” legal liability exposes auditors to 100% of the potentially devastating consequences of a breakdown or failure. Inadequate as the financial resources of a Big Four firm are to protect itself from a deathblow lawsuit, the ability of a smaller firm to assume a meaningful share, monetarily or by percentage, is immaterial.

That limitation assures that the risk-management evaluation of a Big Four firm as principal auditor, persuaded or obliged to share a large audit, will include the time and attention of a full-court press on the actual performance by the smaller firm – involving substantial duplication or overlap and negative consequences for the achievability of cost efficiencies or real sharing of experience or expertise.

Conclusion

There continues to be no sign of official awareness, that none of the proposed “solutions” to the perceived issues around Big Audit is feasible, achievable or capable of affecting audit quality or competition – a fact so far without impact on the public discourse.

Joint audit, among them, is another “non-starter.” Which reinforces the suggestion here that, sooner or later, the intrusion of reality into the discussion should become compelling.

 

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