Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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The Accountants Are Toasting ESG -- With Loving Cup or Poisoned Chalice?

The accounting profession is joining in the broad-based enthusiasm for a future of greatly expanded attention to corporate reporting in the areas of Environmental, Social and Governance / Diversity, Equity and Inclusion. Whether the stampede is toward a new promised land of useful information, or a cliff-edge of hazard -- that remains to be seen.

My own recent contribution appears in this winter's special edition of the International Journal of Auditing (V.26, Issue 1), published by Wiley in the United Kingdom at the initiative of Dr. Ilias Basioutes, senior lecturer in Accounting at the Aston Business School in Birmingham, as an extension of the annual Audit & Assurance Conference under the auspices of the school and the Audit Group of the British Accounting Association.  With his kind permission it appears here:

THE FUTURE OF EXTERNAL AUDIT: ISSUES AND QUESTIONS 

Introduction

Prediction is very difficult, especially if it's about the future!

- Attributed most reliably to Danish physicist Niels Bohr

What does the future hold for ‘Big Audit’—the function that emerged in the Victorian era 1 to offer third-party assurance on company-provided information, valued and used by the world's capital markets?

Audits of public company financial statements, leading to the all-too-familiar ”true and fair view” opinion, are at the core of a formidable professional services franchise.2

Pressures on the model are multidimensional:

• The traditional ‘pass/fail’ opinion is criticized as simplistically inadequate to address the complexities of modern business reporting.
• The firms are stressed to embrace rapid developments in technology, big data and artificial intelligence and to cope with staffing and employee issues under the COVID-19 pandemic and the work/life concerns of younger generations of their workforce.
• Despite decades of attention to audit quality, costly corporate collapse and white-collar malfeasance persist—in recent years spanning from Carillion in the UK to WireCard in Germany. Highly publicized scandals generate both the expected question, “Where were the auditors?” and litigation at levels posing existential threat to the firms' survival.3

Little should be expected from the politicians and regulators. The consultation initiated by the UK government in March 2021, “Restoring Trust in Audit and Corporate Governance,” portends extended attention to the mission, scope and structure of a reconstructed UK audit regulator but is essentially silent on changes to the basic model of the firms themselves.

Driving real change, however, will be the loud and demanding calls for expanded corporate transparency in a multitude of areas— loosely gathered as Environmental, Social and Governance (ESG) and lately extended to the rubrics of Diversity, Equity and Inclusion (DEI).

Under the imperatives and opportunities of the capital markets, new corporate disclosures may be supported by third-party assurance from sources still to be determined. In that new landscape, where would the accountants find themselves? What might or could they do? Prudently considered, what should they do?

The Accountants Should Be There

The accounting profession has a prima facie claim for a seat at the table. Evidence that assurance providers were “counting the stuff’ goes back to the Sumerian era, when clay tablets were inscribed to record quantities of grain and livestock. At the meta-level, the auditors have provided assurance process innovation and application for 170 years.4 Whether that history supports a claim for primacy may be another matter.

Along with the accounting firms themselves, bodies including the International Federation of Accountants, the ICAEW in the United Kingdom and the Center for Audit Quality in the United States are tub-thumping advocates of a presumptively leading role for the profession.

Observers such as Sir Donald Brydon are more measured. His report of December 2019 on his “Independent Review into the Quality and Effectiveness of Audit” expresses the desirability of a new professional designation—the corporate auditor—contemplating a remit well beyond that of statutory auditors, “to encompass today's auditors and others with appropriate education and authorization” (¶ 6.0.11).

The Brydon report's salient observations suggest that the range of subject matter expertise and competencies required to put flesh on the auditors' process skeleton may be more extensive than is presently available or as envisioned in the self-regarding eyes of the profession itself (all emphasis added):

“... It is far from clear that an accountant is best placed to opine on many of the variables involved (¶ 6.0.13).

“Whilst in this new environment there may be environmental auditors, cyber security auditors and financial statement auditors, only some would need to have an accountancy qualification as known today” (¶ 6.0.14).

Some Threshold Questions

There are threshold questions in the ESG/DEI discussion, answers to which are still on the far horizon. They start with the challenge of articulating the “standards” against which companies will report and under which auditors may provide some form of assurance.

Simply, what is a “standard,” and how is it to be interpreted, applied and enforced?

Ad hoc communities of the great and the good are vying among themselves to proclaim both virtue and competence in standards setting. Self-designation carries no real weight, however; history teaches that stature and credibility are only achieved, and legitimacy bestowed and maintained, through public acceptance, when and if value is demonstrated and responsibility is accepted and enforced.

There is some inchoate understanding, visible among the players, of the uncertainties involved:

• The merger of the International Integrated Reporting Council and the Sustainability Accounting Standards Board into a newly launched Value Reporting Foundation reflected the reality that streamlining and convergence are essential.
• On 3 November 2021, the IFRS Foundation Trustees announced the long-awaited and much-promoted launch of the new International Sustainability Standards Board, one approach to the ultimate need for broadly endorsed official standards recognition and sanction.

Complete global convergence is unlikely, however, as already signaled by separate efforts of the SEC in the United States on climate disclosure and unilateral movement in the European Union toward mandated assurance.5

The Overhanging Issues of Liability 

The skunk at this otherwise optimistic and congenial garden party is that of legal liability. While the prospect of major exposures looms on the horizon, there is no likelihood of short or medium term change in the liability exposure for auditors offering ESG/DEI assurance:

• Barring the unlikely adoption of “safe harbour” protection for assurance in whatever form, inevitable lawsuits will assert liability based on the broad association of the provider's name and brand, whatever the ostensible limitations of its report language. Under the particular conditions of each individual case, it will be asserted that the “standards” were unsatisfactory or deficient to protect the interests of users, or that if the standards had only been properly understood and applied, an allegedly deficient report would and should not have been issued.
• Engagement contract provisions between auditors and clients, to cap or otherwise mitigate potential exposures, have failed to attract widespread or indeed any significant adoption. Public companies in the United States are prohibited by the SEC from using such provisions in any event. Future adoption cannot be anticipated.
• There is no public appetite to relieve the auditors of their generally unlimited liability to investors and others; no realistic expectation exists of liability “reform,” caps on damages or other relief.

Some Nightmare Examples

When an assurance engagement thought to be low risk does go wrong, as some number surely will, the consequences can be wildly disproportionate to a firm's approach to its risk assessment or to the quality of resources and performance actually delivered.

It requires little enough to hypothesize a menu of situations that would spawn serious litigation against ESG/DEI assurance providers, whoever they may be—auditors or others:

• Hard on the heels of an opinion on the controls and governance of a dealer in precious metals, a whistle-blower reveals the entity to be engaged in systematic gold smuggling and money laundering.
• Within a year of an environmental safety report, offering assurance on a global energy company's procedures for controlling the completion of its offshore oil wells, a new blowout occurs on the scale of the 2010 Deepwater Horizon. Weeks are needed to bring it under control; it causes unquantifiable ocean pollution and damages in the billions to regional businesses, fisheries and wildlife, resorts and tourism.
• Directly after a “reasonableness” opinion on a global clothing manufacturer's disclosures of the structural safety of its factories, a high-rise sweatshop in a developing country collapses. Building and contents are a total loss, along with extensive fatalities among the trapped workers.
• An assurance report is delivered on a company's compliance with its country's standards for the number of vehicles necessary for timely evacuation of a factory's workers in an emergency. Unfortunately, a massive accident destroys the facility, with an 80% fatality rate among the workers. Subsequent investigation reveals that while the number of vehicles on site was in compliance with the minimum set by the standards, one third were inoperable and awaiting maintenance; in any event, even the total number could at most have accommodated no more than half the number of workers on site at the time of the evacuation order.

The Profession’s Own Perspective

Optimism and “success bias” are deeply embedded in the DNA of the accounting profession. Well they should be, to meet the complex needs involved in building and leading large organizations in fast- evolving conditions.

But—a personal perspective—in dealing for nearly 50 years with the threats against auditors in their most difficult and dangerous situations, I have long seen their continuing desire to focus on “all the things we do right, that we never get credit for.”

That is especially true for assurance other than statutory audit— whether compilation or reviews, agreed-upon procedures or opinions worded in “limited” or “reasonableness” language. For these, the default attitude is “they're low risk, and people have to understand our role.”

Both of which are true, most of the time. But not always. To invoke the maxim for the occasional discipline of unruly small children, “When I do good, nobody remembers; when I do bad, nobody forgets.”

As For Possible Future Directions?

So what might the future hold? Assuming medium-term formalization of standards and reporting for ESG/DEI, either voluntarily or by official mandate, and the publication of a critical mass of assurance reports, there will follow a small but non-zero number of corporate breakdowns that involve and implicate the performance of the providers.

Some number of accountants and other assurance providers, convinced to accept engagements to provide “limited” or “reasonableness” opinions, will find their work challenged in the courts. Defenses against asserted damages at potentially catastrophic levels will be required. Litigation outcomes being unpredictable, at minimum those firms will incur and expend extensive time, expense and settlement costs.

Other providers, in their exercise of risk assessment, will have foregone the acceptance of ESG/DEI assurance engagements, unless protected from exposure to potentially ruinous liability. It may be expected that such decisions will predominate both in the US and for ex-US companies whose US-traded securities open the door to litigation under that country's legal system.

There is a third scenario for the accountants, if allowed to chart their own course over an uncertain ESG/DEI landscape that lacks dependable signage and is fraught with hazards. By analogy to the tax consulting services that the firms have delivered for decades, they would have a consultative role, both valuable and manageable, bringing expertise and discipline in support of their clients' disclosures, while refraining from extending their own opinions where the value is uncertain and the risks are increased, unpredictable and beyond quantification.

Two factors could complicate such a strategy. The first is that zealous regulators could attempt to mandate ESG/DEI assurance, despite or without adequate assessment of the limitations and complexities.6

Second, the scope of technical competencies and expertise required to support broadened ESG/DEI reporting and assurance has potential to clash with the rules of independence and permissible scope of services that constrain the accountants, particularly in tension with their statutory audits.

That is, because ESG/DEI assurance is likely to be viewed by regulators as insufficiently related to statutory audit to be a permissible service to those clients, firms could be deterred from investing to build that practice in the first place. Further, attempts to house these ancillary non-audit resources inefficiently in separate parts of their organizational structures may not satisfy narrowly read prohibitions. At worst, the competitive tensions between separate practices could renew and exacerbate the dynamics that led to the divorce between audit and consulting that split up the Arthur Andersen organization in the late 1990s.

Conclusion

It should surprise nobody that the concerns in this rapidly evolving area are real and complex. Absent full and robust attention, constructively addressed at an early stage, adverse consequences can be expected; because they are identifiable now, they will not in the future honestly qualify as “unintended.”

 

1 Research in the archives of the British National Library for my book,  Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms (Emerald Books 2d ed 2017), pages 28–34, shows what may be the first modern independent auditor's opinion, dated and signed by William Welch Deloitte on 8 February 1850, on the financial statements of the Great Western Railway for the half-year ended 31 December 1849.

2 Together, the dominant Big Four international networks—Deloitte, EY, KPMG and PwC—have over 1.1 million employees and generated 2020 global revenue of $157 billion.

3 For calculations of the shockingly low litigation “tipping points” that would drive a Big Four firm into the death spiral that was fatal to Arthur Andersen in 2002—never publicly disputed or contradicted—see pages 56–64 of Count Down.

4 This was Mr. Deloitte's description of his scope for Great Western in 1850 (see Count Down page 31):

“Every item has been minutely examined by the Auditors, the vouchers and receipts have been inspected, and the purpose to which the payments were applied has been ascertained. “

5 A close-by context confirms that view, by analogy: The widespread adoption of the International Financial Reporting Standards for financial statement reporting has not overcome some local authorities' retention of their own reporting frameworks.

Broader still, as if confirmation were needed that there will be no arrival at a Nirvana of fully converged ESG/DEI standards, consider the impact on the global economies of the costs and inefficiencies of such competing national choices as between left versus right-hand driving, or the use of imperial versus metric measures of weights, volumes and distances.

6 If so, it would not be the first instance of such overreach. The consequences are still developing on the EC's misguided imposition of mandatory auditor rotation. Meanwhile, in the United Kingdom, only an outbreak of good sense stands in the way of the government's consultation proposal for “mandated shared audits” for FTSE 350 companies.

 

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Big Audit Leaves Russia – Or Does It?

Rapidly as world events are moving, it’s my pleasure to share my guest post of today on The Dig, my friend Francine McKenna’s always sharp-pointed substack, with her incisive sub-head:

“Ties were severed with an ease and speed that suggest the auditor global networks may be more fragile than advertised.”

"We should go" -- Chris Woolf (Ben Affleck), The Accountant (2016).

We’ll only know with the judgment of history whether the large global accounting networks’ readiness to separate from their member firms in Russia had any impact whatsoever on the political and economic outcome of Russia’s invasion of Ukraine. For now, as Churchill described the actions of Russia in 1939, “it is a riddle wrapped in a mystery inside an enigma.”

Two-plus weeks into the increasingly bloody morass of Vladimir Putin’s “special military operation,” however, there can be these observations:

• The largest six networks (as of this writing) have acted to join an ever-expanding list of firms and companies, public and private, choosing the right side of history by withdrawing from Russia.

• Which said, the accounting networks’ structures and the nature of the Big Audit model –- both differing fundamentally from those of the world’s largest corporations and the lawyers, consultants and other professional service providers – mean that in actual practice the impact is likely to be minimal.

• Once beyond the immediate optics and a modest amount of house-keeping, the ease and speed with which these amputations were carried out suggest that future distress scenarios should be seen as dire.[1]  

Grant Thornton led on March 1, and then the terminations came raining down –- PwC and KPMG, EY, Deloitte as the last of the Big Four, and BDO on March 9. The pack of red cards lagged business cessation announcements by McKinsey, Apple, Nike, and a partial but growing list of the large law firms, although ahead of giants in the consumer sector — McDonalds, Coca-Cola and Starbucks — and lately even bankers Goldman Sachs and JP Morgan Chase.

Their public face was one of collegial amiability; if couched as divorces, they would anticipate future reconciliation or re-engagement. EY’s press release offered comfort that the “EY global organization assured that it would provide assistance to Russian employees.” PwC Russia put it that, “This transition is expected to be smooth and the PwC Global leadership team has stressed that it would make every effort to support our Russian colleagues and firm through the process.”  

Looking ahead, the tone of the announcements fairly brimmed with confidence:

• PwC stated that, “The principles and rules of working with clients in Russia will remain unchanged.”

• Over at EY, “EY Russian practice is providing and will continue to provide services to all its clients in accordance with high quality standards based on international methodologies developed by the global organization, which will continue to provide methodological support to Russian practice.” 

The basic organization of the large networks portended the up-beat tone. As well enough known but seldom scrutinized, they are assemblages of distinct and separate legal entities, organized and providing client services at the local country level to comply with the local nature of the profession’s regulation. They are, for the most part, various types of private partnerships, owned by their local partners who share profits and losses at that level. They do not have outside third-party capital, a corporate “parent,” or a top-level “holding company,” although most have some form of non-practicing administrative entity that is inserted into a complex web of inter-firm contractual agreements to facilitate the handling of intellectual property, methodology sharing, quality oversight, personnel transfers and the like.

Very little need change to maintain the status quo. Daily life at both the newly-outcast Russian firms and their quondam colleagues ex-Russia will evolve in ways that are both marginal and limited. That’s especially as compared to the disruption being caused by outside forces, as the array of Western sanctions on companies and individuals both Russia-based and doing business there looks expansive, targeted, and significant.

Those effects, however, would befall the accounting networks and firms whether the Russian members were in or out.

• Employees of the newly-isolated Russian firms will continue to work the same jobs, at the same locations and under the same leaders as before.

• The fortunes of the Russian partners will continue to depend on their on-going local practices –- although as noted, impacted by Western sanctions –- but not radically different from under the large networks’ localized compensation ethos of “eat-what-you-kill.”

• Change management will be trivial. Clients and other interested parties will have received the news of the Russian firms’ status almost instantaneously. With marginal effect in the marketplace, the firms’ publicity resources will be occupied briefly with revised branding announcements, re-labelled publications, website re-designs and the issuance of new business cards.

Nor is there any reason to doubt the limited nature and scope of the impact on the execution of Big Audit engagements. For these, there are two aspects:

• An audit firm in Russia, engaged by a client based there and having international operations, would always have relied on its collegial network member firms to perform any necessary non-Russia work. That need will continue, although under the global-level assurances of on-going cross-border amity, it will be uninhibited by the cosmetics of separation (while, as noted, very possibly affected by the sanctions regimes).

• Symmetrically, the auditor of a non-Russia company with operations in Russia will have relied traditionally on its member firm there to audit and report on the local results. Again, going forward (and noting that the audits of companies exiting or halting their Russian business may now have to address the accounting for operating losses or discontinued operations), the local Russian firm would presumably be available to be engaged at arm’s-length — deploying its personnel and relying on the non-Russia referring firm to provide technical consultation and methodology guidance, just as a large network has always done to secure services in a country where it might not have its own network member. 

So far, very likely all well and good, if lacking in drama — save for this: when the violence has ended, and the dust of the Russo-Ukrainian conflict has settled, both literal and figurative, a dark and subtle message lurks beneath the surface.

Consider that the large audit networks have thrived on messages emphasizing the scope and strength of their international structures, and their capacity at scale to deliver seamless and efficient services to the participants in the global capital markets.

Those messages have persisted, despite an emphatic signal delivered in 2002, when the Arthur Andersen network collapsed in a matter of weeks. This occurred even though it was the most profitable and tightly-organized, with its partners enjoying the only globally integrated results-sharing model in the profession’s entire history. 

Which is to say — the largest six networks have now shown the capacity to surgically excise their Russian member firms, voluntarily and in a matter of days. That suggests — under-cutting the messaging of network unification as robust and tightly-bound (and shifting metaphors) — that the “ties that bind” may only be attached with slip-knots, or are spun of gossamer, able to being broken or snipped in an eye-blink by the scissors of exigent events.

I have long argued that the under-appreciated lesson in Andersen’s precipitous fall was that, far from being “too big to fail”, the surviving Big Four tetrapoly is “too fragile to survive.”[2]

That every one of these large networks was able to cut loose a member firm of significant size, swiftly and without obvious discord or repercussions, does not inspire confidence that a similar fate would not befall an organization under the stress of a government sanction or a litigation judgment at a level — easily foreseeable, given the size of recent well-known corporate failures — that would threaten the limited depth of its capital structure and its individual partners’ resources.

Modifying network structures that have included Russian member firms, over to on-going relationships with now free-standing Russian local firms, should work smoothly enough, considering the size of the Russian economy in an overall global context. Tightly knit as are the activities of the companies and the sources of capital that make up the large western economies, however, the case would be far different should a large network be forced to lose a local firm in, say, a G-7 country or a handful of others.  

That prospect is worthy of a discussion, when a post-wartime context allows, that deserves to be held explicitly and in full public view.

 

[1] By way of disclosure, my legal practice has for five decades been focused on the accountants. I was a partner in the Arthur Andersen worldwide organization and a senior member of its in-house legal group until the spring of 2001, and continue with on-going relationships both personal and professional.

[2] Please see, for example, my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books 2d ed. 2017, pp. 45-64).

For more about this subject see an excellent summary of the issues, “Why the Big Four’s Russia Pullout Isn’t a Clean Break: Explained,” by Amanda Iacone and Michael Kapoor.

 

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Reporting and Assurance on ESG/DEI –- Measuring the Long Road from Here to There

I often wonder what the vintners buy –

One half so precious as the goods they sell.

             -- The Rubaiyat of Omar Khayyam (FitzGerald trans.) 

Controversy fills the daily news over standards of behavior –- enforcing compliance and sanctioning deviance around mask mandates, drug tests for Olympic athletes, and even the invalidity of thousands of infant baptisms for a priest’s use of a single incorrect pronoun.

So it’s with a combination of enthusiasm and apprehension that I struggle to follow the Babel of public conversation that seeks expansion of large-company disclosures on Environmental, Social and Governance, and Diversity, Equity and Inclusion.

There are a host of issues, to be explored here in due course; these are only a handful:

• Should ESG/DEI reporting be mandatory or voluntary?
• Should there be expert assurance –- if so, by whom?
• How best to measure non-compliance?
• Who should be accountable, and with what sanctions?

Before any of these can be discussed, much less resolved, this at the threshold:

What qualifies as a standard? And what chance is there for broadly-accepted standards for ESG/DEI reporting and assurance that are coherent, comparable, and credible?

As Amanda Iacone wrote for Bloomberg in December, “Investors hungry for information about corporate climate risk and performance on social issues want some confidence that the data companies report are accurate and calculated consistently from year to year.”

The community of information users who live in the eco-system of traditional financial reporting, accounting and assurance standards have nailed their colors to the mast of the International Sustainability Standards Board –- newly-formed late last year and slowly ramping up its staffing and early agenda development.

But as Iacone surveyed 2020 reporting by S&P 500 companies, “Engineers and boutique firms that specialize in sustainability metrics were among the (assurance) providers, along with accountants. Combined, those providers relied on a jungle of testing standards that mirrors the confusing mix of frameworks that companies rely on to create their reports.”

Foreseeable disclosure and reporting challenges, then, will plainly include, as she put it, “Inconsistent testing of voluntary ESG reporting –- including the myriad providers and the varied scope of the assurance….”

Pondering society’s resistance to converging over “what is a standard” -- the very baseline requirement before all others -- I am preparing to travel between Paris and London for meetings where this high-level question will figure.

My chauffeur to Gare du Nord will be in his Uber’s customary left-side front seat; he will use the dedicated taxi lane on the right. On his way to pick me up, he would have pulled over a droit for fuel, measured in litres and paid for in Euros. If necessary he would have checked his tires –- the pressure gauge measuring in kPa, that is, newtons per square meter.    

All routinely consistent with the standards and practices of tens of millions of motor vehicles in Europe.

Two hours and a bit on the Eurostar will include the 50.5 kilometres in the Channel Tunnel between Calais and Dover – that is, 31.35 miles, depending on who’s counting.

At St Pancras Station I will hail a cab, pulling up from the taxi rank’s left-side lane. The driver, behind the wheel on the cab’s right-hand side, will have started his day by taking on petrol by the gallon, paid in pounds sterling. His British tyre gauge would have measured in “psi” – that is, pounds per square inch.

He'd have thought nothing of the applicability of those quotidian standards.

Nor are the English and the French about to change or converge any time soon.

Borrowing from an elder source of wisdom, as I peel another page from my yearly calendar, “The older I get, the more respect I have for the phrase, ‘Not in my lifetime’.”

Investors and other data users who provide capital to the world’s markets have their appetite for ESG/DEI information fully displayed. Broadly suitable standards that will achieve their support are, however, a considerable distance far down the road –- however that distance is measured.

 

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Luckin Coffee – What’s Brewing In China?

With the echoes still ringing from China-based Luckin Coffee’s $ 300 million accounting scandal in 2019, the company is reportedly planning to relist its shares in the United States.

The American regulators –- the Securities and Exchange Commission and the Public Company Accounting Oversight Board –- might actually buy this remarkable assertion of restored corporate virtue. It will be a test of the policy and enforcement commitment of these erstwhile gate-keepers.

There’s ample room for doubt. My own views are well recorded: American policy toward Chinese companies has been incoherent and inconsistent for years, most recently with the Holding Foreign Companies Accountable Act of last year, with its can-kicking three year extension before Chinese companies with uninspected auditors might face de-listing.  

Looking back:

• The wave of reverse mergers by which Chinese companies gained access to US listings in this century’s first decade caught the SEC on the back foot.
• The agency was played like a chump in its 2015 smoke-and-mirrors “settlement” regarding enforcement subpoena responses by the large accounting firms.
• Meanwhile the PCAOB has been stymied since its launch in 2002 by the inability to inspect and access the working papers of auditors reporting on enterprises in China.

As for Luckin’s post-scandal history: 

• The company’s NASDAQ-traded American Depository Shares were de-listed in June 2020; its founder/controlling shareholder was forced out; and it filed for bankruptcy in February 2021.
• It was recapitalized with the injection of $ 250 million from two Chinese private equity groups, reportedly connected to the company’s earlier history, ahead of the availability of audited financial statements.
• Under an agreement announced by the SEC on December 16, 2020, the company agreed to pay $ 180 million to settle securities fraud charges based on $ 300 million of fabricated sales and $ 190 million of inflated expenses.
• In October 2021 it agreed to pay $ 175 million to settle shareholder class litigation –- with a court approval hearing scheduled for July 22, 2022.

On September 21, 2021, the company filed its annual report on SEC Form 20-F, covering the years 2019 (as re-stated) and 2020, supported by the clean audit opinion of Centurion ZD CPA & Co.  That firm, a one-office operation in Kong Kong, described on its website as formed by the April 2016 merger of Dominic K.F.Chan and AWC (CPA) Limited, succeeded Marcum Bernstein & Pinchuk, which had replaced EY post-scandal but resigned for its reported inability to audit and report on the company’s results for 2019 and 2020.

Which is where things should get interesting for the American regulators.

Centurion states that it “provides a comprehensive range of services on a global perspective,” across the range of “audit and accounting services, taxation, risk assessments services, corporate finance consultancy and business advisory services.”

To offer such a range, the demands on Centurion’s personnel and modest size are considerable. Its website names just six directors including Managing Partner Chan. Its report to the PCAOB for the year ended June 30, 2021 (Form 2), shows a total of 52 accountants of whom 18 are certified.

The Form AP filed with the PCAOB on October 26, 2021, for Luckin shows the engagement partner to be Managing Director Chan himself. Chan spreads himself widely: for the firm’s US registrant clients (see the SEC’s listing of companies for which inspection reports are not available), he and his colleague Wing Wai Lai are named as the engagement partners on 25 of the 35 Form AP reports filed with the PCAOB in the last twelve months.

As for Centurion’s capacity to handle the demands of auditing a company the size of Luckin, its resources must measure against the currently-reported size of the company: third-quarter 2021 revenue increased 106% to $ 370 million, derived from 5,671 stores, mostly on the Chinese mainland, and a market valuation above $ 2.5 billion. 

History provides ready examples that serious financial malfeasance can be facilitated by the over-reaching of small practitioners:

• The multi-year scheme by which Rita Crundwell embezzled $ 54 million from the city coffers of Dixon, Illinois –- where a regional firm issued compilation reports, while the principal of a two-person local accounting practice signed the audit opinions (and was eventually able to contribute a modest $ 1 million in litigation settlement).
• Bernie Madoff’s flamboyant Ponzi scheme, abetted by a sole practitioner practicing out of a suburban strip mall office, who in his plea of guilty to securities fraud acknowledged simply “rubber stamping” Madoff’s fictitious filings.

Providing color to the lurking questions of Centurion’s resource and expertise adequacy are indicators that its relationship with its regulators is generously described as uneasy at best:

• On October 27, 2011, the PCAOB’s inspection report on the predecessor Chan firm found actionable audit deficiencies at two of its then four SEC-registered clients, including failures to obtain sufficient audit evidence relating to the accounting for convertible debt and preferred stock and also compensation expense –- also noting that the Chan firm did not respond when offered the opportunity to comment on a draft.
• On May 19, 2016, one month after the Chan/AWC merger that formed Centurion, the PCAOB announced sanctions against AWC and related parties, including its principal, “Albert” Wong Chi Wai. Among other things, “AWC improperly relied on management representations in auditing cash and revenue and ignored numerous red flags indicating potential fraud and undisclosed related-party transactions.” AWC and Wong were censured, each was penalized $ 10,000, the firm’s PCAOB registration was revoked, and Wong was given a two-year practice bar.
  • According to the Centurion Form 3 filed with the PCAOB on November 29, 2017, the Hong Kong Institute of Certified Public Accountants reprimanded the Centurion firm and imposed a penalty of HK$ 25,000 and costs of HK$ 10,000, apparently related to the above PCAOB proceeding.
• On September 26, 2017, Centurion reported (PCAOB Form 3) that Chan and his predecessor firm were reprimanded by the HKICPA and jointly fined HK$ 30,000 and costs of HK$ 10,000, for breach of the standards relating to non-recognition for deferred tax liabilities in connection with a client acquisition.
• On June 24, 2019, the firm reported (Form 3) the HKICPA’s personal reprimand of Chan and a penalty of HK$ 80,000 and costs of HK$ 36,630, for a client on which Chan was the engagement partner, responsible for mistakes in calculating the company’s loss per share.
• In its press release dated January 15, 2001, the HKICPA announced action against Chan as sole proprietor of the Chan firm in connection with a review report for the period ended December 31, 2018 –- two years after the Chan/AWC merger –- relating to misclassifications and related deficiencies, reprimanding Chan and the firm and imposing a penalty of HK$ 50,000 and costs of HK$ 15,000.

 If Luckin does pursue its re-listing attempt, it will rest with the SEC and the PCAOB whether all or any of this should move the agencies into action.

They could, of course, choose the passive course, deferring under the HFCAA’s three-year non-inspection trigger, leaving investors in the meantime to pour their funds into a hole as black as Luckin’s darkest expresso.  

But should they? The agencies’ tools under the Sarbanes/Oxley regime are all at hand: With its 2021 annual report in plain sight, Luckin’s business plan remains criticized -- its ambitious growth plans fueled by customer discounts at levels that guarantee long-running losses, and little chance to convert to profitability by raising prices, with competition fierce and customer loyalty fickle. 

 While the PCAOB has not reported on an inspection of Centurion since that of its predecessor in 2011, the firm if asked today would presumably deny inspection and workpaper access. De-registration could promptly follow as a matter of course. No re-listing of Luckin would happen -- instead a potential new scandal averted.

 

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PwC’s UK Head Is Unhappy -– There Could Be Relief

“When sorrows come, they come not single spies, but in battalions.”

                    -- Claudius, Shakespeare’s Hamlet (IV, v)

How much concern do we feel for Kevin Ellis? He should sit pretty -- senior partner of the UK firm of PwC, which in 2021 clocked up record global revenue of $ 45 billion. The average profit of his UK partners was a league-leading £ 868,000, and Ellis himself in 2020 took home a handsome £ 4.4 million.

Instead, this week’s press attention finds him in a double bind, triggered by the UK’s audit regulator, the Financial Reporting Council. Even in paralysis over its structure and its remit, with the whole topic of “audit reform” on hold as the Boris Johnson government totters for survival between the fiascos of Brexit and COVID, the FRC has seen fit to widen its investigation of PwC’s audits of Babcock International –- expanding from 2017 and 2018 to sweep in the last two years before the firm was replaced by Deloitte.

In the usual grim ritual, the firm’s response was the expected if defensive pledge of obeisance and cooperation:

“We will cooperate fully with the FRC in its inquiries,” said PwC in a statement. “Audit quality is of paramount importance, and we remain committed to our ongoing program to enhance audit quality and to the delivery of consistently high-quality audits.

“The FRC’s annual reviews of our audit work, policies, and procedures show a continued trend of improvement in our work, and we use their insights, together with our own reviews, to continuously improve how we deliver high-quality audits.”

Ellis chose at the same time a gratuitous reprise of his frustration as previously aired to the Financial Times:

“(C)riticism of the audit industry from politicians and regulators was harming the profession and risked making it more difficult to attract new recruits.

“Retaining qualified auditors also ‘becomes much harder, if there’s a current of external negativity,’ he said.”

PwC’s prosperity in the COVID era considered, critics would be tempted to charge Ellis with tone-deaf ingratitude, except that his distress lies in the inability of Big Audit to accommodate two conflicting positions: The profession’s leaders self-confidently resist the recognition of atypical but inevitable instances of sub-optimal performance, while the public’s pointed question in any case of significant scandal is, “Where were the auditors?” 

Little wonder, there is skepticism about the profession’s legitimacy -- among investors and other users, with new graduates exploring their career paths, and as maturing staff decide where to commit their energies and their fortunes.

History teaches that the accounting profession has never rested easily in its relationship with its regulators. In the 1860s, the nascent profession -- counting among its leaders both Messrs. Price and Waterhouse -- fought off legislative attempts to require that government should audit the UK railroads. Its franchise of privately-provided audits of public companies was only later secured with passage of the core American securities laws of 1933 and 1934.

It’s been downhill since. Indeed, with this month’s fourth anniversary of the collapse of Carillion, Ellis might appreciate the FRC’s pointing its limited artillery at KPMG’s former partner and staff, who have turned on each other under charges of manufacturing and post-dating Carillion working papers and other engagement documentation.

Possible relief for Ellis’s dour pessimism is available, although it would require legislation, cooperation, and deep changes in attitude on the part of all the players –- starting with the auditors and including companies, information users, legislators, and regulators.

That is, it is to the profession’s discredit that Big Audit lacks a forum in which audit performance quality can with credibility be investigated, evaluated, and if necessary sanctioned. The available tools are not serving. The FRC -- derided in the post-Carillion studies as “a ramshackle house,” and “toothless and passive” -- is perceived as non-transparent, inefficient, and ineffective. And the legal systems that continue to threaten “joint and several” liability on the scale that destroyed Arthur Andersen in 2002 are seen as ponderous, erratic, and unpredictable.

To address these issues, a tribunal could be designed for “audit failure study” -– drawing on a long and successful history among the other professions. In hospital surgeries and emergency rooms, engineering studies of infrastructure collapse, assembly line disruptions and air and rail accidents, learning emerges in the study of catastrophe, from the inadequate number of lifeboats on the Titanic to the construction deficiencies in the World Trade Center.[1]  

The outputs of a well-constructed body -- given a broad remit, a legislative mandate, and the necessary expert and staff resources –- would:

• Enhance the credibility of corporate issuers’ commitments to quality reporting.
• Support the accountants’ legitimate aspirations and claims of improved performance.
• Provide guidance for standard-setters.
• Offer clarity and transparency to investors and agencies of government.

Resistance would of course be expected. Inertia and preservation of the status quo are never easy to displace. The profession’s leaders and the communities of information issuers and users would all be required as willing participants –- endorsing the value of such a tribunal as a matter of mutual trust and appreciation of its value.

As for Kevin Ellis and his concerns, a credible body for the study of his profession’s quality issues would provide a point of reference to which he would steer the interests of his audiences –- sparing himself the impossible task of preaching to the unconverted and allowing him to focus on more productive efforts. 

 

[1] For an extended examination of the complexities, challenges, and benefits of “failure study,” please see pages 285-292 of my 2017 book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books 2d ed.)

 

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Hazards in the UK Audit Market – A Parable for the Holidays

Bidding farewell to this dismal year, it’s my long experience with the holiday season in the United Kingdom that a significant matter open on the solstice will not receive attention through Christmas, Boxing Day and the New Years celebration, until after the arrival of the Three Kings.

So today’s news is welcome, that Boris Johnson’s beleaguered government actually has a candidate -- the seasoned Jan du Plessis, late of BT and Rio Tinto -- to chair the Financial Reporting Council. But the post requires parliamentary committee approval to head the audit regulator, an agency itself hostage to the absence of legislation to relieve its “ramshackle” condition. Further official delays and inaction look inevitable, well into 2022, in untangling the complexities contained in the depressing question, “Where were the auditors?”

While the prospects are slight that the arrival of du Plessis will herald a secular epiphany, there is at least a learning opportunity in the recent reporting that HSBC’s approaching obligation to put its audit out for tender may well attract no proposals save from incumbent PwC. 

That is, the needless distractions over auditor tenure –- under UK and EU rules that have been in place long enough to demonstrate the absence of discernible effect on either audit quality or competition and choice -- are relevant to the still-pending possibility that the UK government’s long-delayed action on its consultation of March 18, 2021, will include either “managed shared audits” for FTSE 350 companies, with the forced participation of the smaller firms, or attempts to impose “caps” on the Big Four firms’ market share.

Namely, with the indicated lack of enthusiasm among PwC’s three large brethren,  the unlikelihood of change at HSBC is further confirmed, according to the Financial Times, as “senior auditors at two challengers said mid-tier firms would not pitch to audit the entire HSBC group because of its size and the associated regulatory risk.”

No surprise at all. HSBC is the largest bank in the FTSE 100. PwC’s audit and related fees of $ 130 million last year are, as the FT put it, “more than the entire UK audit revenues of any challenger other than BDO and Grant Thornton.”

Which said, the story in the numbers is not the only way to consider the structural inability of the smaller firms to expand their large-company market share. For a perspective on such an attempt, here follows a first-hand experience, with implications if a “challenger” firm actually tried –- that is, had the chutzpah or the reckless courage -– to propose.  

It was a long time ago, in a galaxy far away –- so far in the past that all statutes of limitations on the telling are long since expired. A small-city office of a then-Big Eight firm wrenched the audit of a complex financial institution away from its main local competitor -- to be the successful aggressor’s only local client in the sector.

With abundant confidence and complete good faith, the newly-arriving firm cobbled together an engagement team headed by the office’s senior audit partner –- experienced and respected in the local community, known for his probity and his leadership, although with a blank slate of specific industry experience. His supporting lead manager’s briefing into the new role was to attend the firm’s internal industry training classes.

The first two years went smoothly enough, save for the weight on the engagement of the expected and greater than normal resort to the national office.

In year three, however, the client pushed into a major new product line, an ambition burdened by start-up operational glitches and accounting complexities beyond the experience and resources of its own CFO and staff.

As for the audit team, this new business went observed but unremarked. Hindsight was later to reveal that they failed to grasp or even recognize the risks and complexities of a business environment they had no way ever to have seen before. 

The finger pointing and blame attribution between client and auditor were intense and unpleasant. The inevitable rupture of the relationship was nasty, including extended litigation and ample unpleasant gossip in the city’s civic venues and country clubs.

Developments in behavioral psychology and economics provide the framework for this parable. At play is the Dunning-Kruger effect -– the cognitive bias under which catastrophically erroneous risk-related decisions are made, where the actors are ignorant of the scope of their own ignorance.

“Not knowing what they didn’t know,” in other words, both the client and the audit team were exposed to fatal defects in their decision-making capability.

Dunning-Kruger is wonderfully powerful as a means for better decisions, but only if recognized in the specific context:

• Applications start with the simple and entertaining -- if told to draw a picture of a giraffe, you have no chance if you’ve never seen one before.
• Scaling up the example to a multi-million-dollar business challenge -- even a highly-skilled professional, unless specifically trained and experienced, cannot conceive, much less carry out, the judgments involved, eg., in fixing and accounting for a realization reserve on the assumption of a portfolio of exotic financial instruments.

In the hypothetical future world of “managed shared audits” or capped market share, the engagement partner of a mid-tier audit firm with big-table aspirations would hang from a limb of uncertain length and weakness. The questions “who can I call?” and “where is my help?” would come back unanswered. 

The various versions of the clichéd doom that awaits those who forget history have even greater force for those never learning in the first place. For future problems of newly-presented scope and complexity, the consequences will be no prettier than they were in my old case a generation ago.   

  

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Brian Kelly Leaves Notre Dame: The Oxymoron of “College Football Ethics”

What lessons from Notre Dame football coach Brian Kelly’s abrupt departure for LSU last month? As so often, where you stand depends on where you sit.

Kelly took up the chance to elevate the Tigers’ 2021 dreary record -- 6-6 overall and anchoring the SEC at 3-5 -- enticed by a ten-year contract for $ 95 million plus multiple incentives. In the Southeastern Conference’s multi-billion dollar program to feed well-muscled young beef into the professional meat-grinder -- business as usual.

Back in South Bend, however, Kelly piled insult on injury:

• Using a Twitter message to inform the players he had recruited and led to the threshold (ultimately frustrated) of the College Football Playoff.
• Taking the phone call that iced his new deal as a distraction from a family dinner with a star recruit, with no disclosure during the homey sales pitch.
• Holding an abbreviated no-questions team meeting at 7.00 the next morning, ahead of his flight by private jet flight to Baton Rouge.

At both schools, the follow-on effects were immediate. Notre Dame filled the vacancy in four days. First-year defensive coordinator Marcus Freeman was promoted on an outpouring of affection, support and lobbying by the team itself, after its sullen reaction to Kelly’s superficial messaging.

Meanwhile in Louisiana, Kelly’s performative introduction was derided as a bogus attempt to transmute his New England origins and Midwestern history into an adopted southern accent. More pointedly, both the Tigers’ starting quarterback and his top-prospect high school brother, Max and Jake Johnson, promptly declared themselves unwilling to be part of a Kelly regime.

Time will tell whether the youthful Freeman will grow to be the Fighting Irish’s next Knute Rockne or Ara Parseghian; in the eyes and hearts of the faithful, he will definitely not be the next Kelly.     

For myself, I hold no brief for the massive industry of college sport. It comes hard, to endorse the inducement of young athletes with transient weekend glory and the prospect of an abbreviated professional career all too likely to end with life-shortening brain damage. Or, where even a fraction of the resources that build athletic palaces and pay the massive salaries of sweat-suited coaches could be deployed to libraries and research facilities and academic scholarships and the scholars to whom we entrust the education of our best and brightest. 

Which said, I forswear negativity or cynicism in the broader purpose of this inquiry. At the law school where I teach in a Masters program in Ethics and Governance, syllabus demands leave limited space for guiding themes and principles. So I look for opportunities to ask about some basics: What impels our human need for laws and codes of conduct in the first place? What different choices do societies make in the balance between incentives and coercion? With the fallibility of humans prone to deviant or non-compliant behavior, should we look to minimize the harm done by wrong-doers, or focus energy on leading by positive example?

The American economy and culture have two major sources for their metaphors –- the military, and sports.

• A corporate raider launches a blitz against its target. Companies competing for workers fight the war for talent.
• A successful mentor is the team captain. Career success brings recognition as an All-Star, or election to a Hall of Fame.

One of the finest trial lawyers with whom I was privileged to work, the late and great Peter Fleming (RIP 2009), drew upon his son’s experience as a D-1 football coach, to illustrate the personnel dilemma of a corporate leader:

“You work your butt off all week, to train and prepare them. On Saturday afternoon they take all that onto the field. And you’re stuck on the sidelines, watching while they surprise you –- for better or worse. Just the same with young employees.” 

It could be said that Kelly’s be-clouded departure was predictable. The broader signals of a tattered ethical fabric were there from the start:

• The 2010 death on a practice field of student photographer Declan Sullivan, sent 39 feet up a scissor lift despite winds gusting to 53 miles per hour.
• The suicide the same year of a sister-school freshman whose report of sexual assault by a Notre Dame football player received minimal attention and no school or law enforcement consequences for the player.
• The vacating by the NCAA of Notre Dame’s 21 wins over the 2012 and 2013 seasons for violations of the rules of academic integrity.

More immediately, not only had Kelly bolted his prior position at Cincinnati before the 2009 bowl games, with the Bearcats on their way to the Sugar Bowl -- he had done the very same in 2006, leaving behind his staff at Central Michigan to coach that team in the Iron City Bowl.

As it’s said, “Karma never loses your address.” Administrators at LSU might consider themselves forewarned by Kelly’s trifecta of premature evacuation. Post-season, before future years’ bowl games, they’d be advised to take away his phone and clamp him in an ankle monitor.

In the first act of Shakespeare’s Scottish play, the action is animated by the off-stage execution of the treacherous Cawdor. An otherwise minor plot device will echo to color Macbeth’s own fate: the traitor is credited with the morality of his final confession and his deep repentance -- “Nothing in his life became him like the leaving it.”

Subject to history’s possible revision, it may be said of Brian Kelly’s graceless flight from South Bend:

“Nothing besmirched his legacy at Notre Dame like the leaving it.”

 

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Chinese Companies in the US: The SEC Should Be Making American Foreign Policy?

Nearly a year into the Biden presidency, the breaks with his predecessor are stark and wide-ranging: the Paris climate accord, Iran, NATO, infrastructure –- and of course, the question whether success against COVID-19 should rely on the science of vaccinations or veterinary medicines for equine heartworms.

In that context, it bears wondering why America’s top securities regulator, Gary Gensler, chairman of the Securities and Exchange Commission, has with enthusiasm embraced one of the prior administration’s least coherent ideas.

By rules finalized on November 5 and December 2, Gensler committed his agency and the US audit regulator, the Public Company Accounting Oversight Board, to the Holding Foreign Companies Accountable Act, passed in May 2020, under which foreign companies would be punished for their auditors’ failure to allow oversight agency inspection and production of their working papers.

Aimed directly at the recalcitrant Chinese, who have refused, since passage of the Sarbanes/Oxley law in 2002, to submit to the enforcement processes of the PCAOB, the HFCAA perches Chairman Gensler on the pointed horns of a dilemma: What shall he do now? 

That’s because it is well enough, at the level of the cheer-leading rhetoric of Washington bureau-speak -- as Gensler’s latest press release put it, “the final rule furthers the mandate that Congress laid out and gets to the heart of the SEC’s mission to protect investors … to ensure that the auditors of foreign companies accessing U.S. capital markets play by our rules.”

Left un-addressed, however, are implications for international policy, well above the pay grade of a securities regulator. At the heart of the matter: is official Washington prepared either to de-register the uninspected Chinese member firms of the large international accounting networks, or to enact stock trading prohibitions and ultimate de-listing of non-compliant Chinese companies?

There are multiple issues:

• To start, application of the HFCAA could not please the bankers and other participants in the American-based portion of the world’s capital markets, putting at risk of exclusion an estimated 250 companies with market capitalization above $ 2.1 trillion and headed by such as Alibaba, Tencent and JD.com.

• The self-interest of the bankers would align with ex-China investors in preserving not only simple trading mechanics, but also the availability of information about Chinese companies, as required under the American regimes, incomplete as may be. There is no indication, for example, that an audit regulator in Hong Kong would be any more successful in achieving inspections and document production than its American counterpart.

• Consistency of approach should also drive attention to the unavailability of auditor information on the enormous China-based operations of the array of giant corporations based or listed in the US –- a simple example being Apple, which steadily generates about one-quarter of its revenue in China although the local Chinese firm of EY’s global network has never made available its personnel or its papers.

• China’s own policy intentions and desires are in play. It may indeed suit that country’s leadership to reel in the listings of its country favorites, bringing them home to the proximate bourses of Hong Kong or Shanghai. That step would be congruent with the evident arm-twisting wrought on the fallen darling, ride-share company Didi, which announced on December 3, in timing most likely coincidental, that it has repented of its US initial public offering and will take steps to de-list in favor of Hong Kong –- a move of scant comfort to the investors who saw Didi’s share price lift from its initial offering price of $ 14 to a high of $ 18.01, only to crash back last week to a range around $ 7.

Finally, the entire recent exercise –- passage of the HFCAA and the ponderous rule-creation process of the SEC and the PCAOB –- is redundant and duplicative of pre-existing authority and tools under Sarbanes/Oxley itself.

That is, as outlined here last May, since the time that law was passed in 2002, its framework has required that both domestic and foreign auditors of US-listed companies submit to the PCAOB; that sanctions for non-compliance would include a firm’s de-registration; that audit reports of a de-registered firm were not permissible for SEC filing; and that the consequences for a company would include trading prohibitions and de-listing.

That authority has gone unexercised for almost twenty years. Now, with the HFCAA lurching into place, its rules contemplate a three-year timetable before sanctions would fall on either a non-compliant company or its auditor. That is, commencement of meaningful enforcement consequences would not start before 2024.

Chairman Gensler having inherited a poisoned chalice of mutually conflicting policy goals and potential unintended consequences of uncertain geo-political scope, he stands before a wide-open opportunity window. There, a prediction may be made with confidence, that political exigencies will yet oblige him to hurl that chalice through the window and as far down the road as possible.  

 

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Cap the Big Four’s UK Audit Market Share? A Message From the Facts

It’s nearly four years since Carillion's collapse in the United Kingdom triggered the latest wave -– “Where were the auditors?” While that question is pursued in the Official Receiver's £ 1 billion lawsuit launched against KPMG on November 19, what passes for broader discussion on the Big Audit model has come down to this:

Proposals for “managed shared audits” -- by which the smaller audit firms would perform a material portion of the audits of the FTSE 350 public companies –- have failed to achieve any traction. Is there an alternative?

Still floated with varying degrees of enthusiasm is the idea of a “market cap” –- enforced reduction of the Big Four’s currently dominant share of the large audits -– cited by, among others, the financial press (here and here), the ICAEW, and the chief executive of the UK’s audit regulator, the Financial Reporting Council.

To be taken seriously?

Nope. A rude reality check would await an FRC ukase to forcibly reduce Big Four market share. However wishful or earnest the attempt, there is no other source.

For the multiple reasons why managed shared audits so lack favor, the same limitations exist no less for the unfortunately-described “challengers” –- BDO, Grant Thornton, Mazars, and the other smaller firms in rapidly-descending size –- and the even greater complexities of their taking on full audit performance and responsibility.

My practice in confronting such a conundrum is to consult my academic colleague, Professor A Fortiori.

He begins with the context: Under the indifference of the Boris Johnson government, and the functional absence of the secretary for business, energy and industrial strategy, Kwasi Kwarteng, the prospects for substantial change of any kind are minimal. Not least, the likelihood of Parliamentary attention, much less actual legislation, necessary to replace the shambolic history of the FRC with the mooted new ARGA, ranks somewhere below the chances that the British will return to Greece the Parthenon marbles looted by Lord Elgin two centuries ago.

Nor is there any real wrangling over changes in the audit model, attention having long dissipated to the post-Carillion trio of official reports and the admirable work of Sir Donald Brydon.[1] Rather than active engagement among the parties, the faint glow of the public discourse has not generated heat enough to brew a tempest in a teapot.

The estimable A Fortiori commends these points:

“Audit quality” being ostensibly the ultimate goal, commentators (as referenced above) point to the spate of recent company failures and regulatory investigations and sanctions against the auditors both small and large, needless to repeat here. With that list, the position of the head of audit at one of the “challengers” -– that “audit firm size isn’t necessarily correlated to quality” –- should bear the qualifier, “one way or the other.”  

The same holds for FRC audit inspections -– summarized by the Financial Times to “not help the challengers’ case” –- although caution in extracting conclusions from the numbers is always appropriate, when a compliance-enforcement agency can design and apply its own procedures and then grades the results of its own work.

More importantly, the inhibitions on the “challengers” actually to assume the up-scaled responsibilities of managed shared audits have not been answered. As sketched out here last April 21, those include: the difficulty for a reporting company to identify operations or subsidiaries to be audited within the capabilities of the smaller firm; the burden on a lead auditor of full responsibility for the work of a “challenger,” with the prospect of expensive duplication or re-performance of work; the geographic constraints on the smaller firms of the globalized operations of the large UK-based companies; and the auditors’ cross-border litigation exposure for companies whose securities trade in multiple jurisdictions, notably the lawsuit-friendly United States.

The glancing mention of market share caps has yet to address the yawning resources gaps of the “challengers” -- industry and technical expertise, geographic presence, experienced partners and managers at the line level, investment funding, financial and risk-oriented resources, that such explosive growth would require.

Further, those invoking the possibility of steps to cap the market share of the Big Four have yet to grasp the enormity of the numbers -– not to say, the practical impossibility of the task.

As outlined here on August 23, audit clients of the “challengers” presently comprise a mere 1.6% of the FTSE 350's total market capitalization of £ 2.219 trillion –- a figure undisturbed by the rapid rise of Grant Thornton client Darktrace from its April IPO through its prompt entry to the FTSE 250 and further October index bump-up. The available numbers indicate that the capacity building obligation of the smaller firms to take on a mooted 20% of  FTSE 350 audit work, over ten years, would require them to add clients with capitalization of £ 41 billion, each year if evenly spread, or if done gradually, at an unrealistic annual growth rate of some 29%.

With all that, a Big Four market share reduction is even less practical or achievable than managed shared audits –- so says the wry A Fortiori.

Although he also notes that continued inattention to the compelling facts on the market structure of Big Audit is likely, as the observably dreary environment in the UK makes it predictable that the entire topic will continue to be kicked even further into the tall grass.

Where it will lie, ignored and unattended, until the inevitable “next time.”

                

[1] Sir John Kingman’s Independent Review of the Financial Reporting Council (December 18, 2018).

The BEIS select committee report, ”The Future of Audit” (April 2, 2019).

The Final Report of the Competition & Markets Authority on its Statutory Audit Market Study (April 18, 2019).

Sir Donald Brydon’s Independent Review into the Quality and Effectiveness of Audit (December 2019).

 

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Book Review -- “Noise: A Flaw In Human Judgment”

For those making group or individual judgments or decisions, on the job or personally: when Danny Kahneman has something to say, listen and learn.

His latest book, co-authored with Olivier Sibony and Cass Sunstein, is “Noise: A Flaw in Human Judgment” (Little Brown Spark, May 2021) –- deservedly long-listed by the Financial Times for business book of the year.

“Noise” extends a history of scholarship that goes back to Kahneman’s ground-breaking essay with Amos Tversky, his long-time and much mourned colleague, “Judgment Under Uncertainty: Heuristics and Biases” (Science, vol. 185, 1974), and was surveyed comprehensively in his encyclopedic work, “Thinking, Fast and Slow” (Farrar, Straus and Giroux 2011).

Standing on the broad shoulders of Kahneman and Tversky, and the two generations of scholars and practitioners who have refined and applied their insights, we look over a landscape of now-familiar concepts -- representativeness, familiarity and anchoring; sunk costs and loss aversion; misaligned incentives and the dangers of not knowing what you don’t know.

Studies of judgment errors have focused over a half-century on bias, with multitudes of strategies for its identification and reduction. “Noise” now offers an awareness of something distinctly different –- the all-too-frequent, under-recognized and undesirable variability of human judgments, in decisions and outcomes that are sub-optimal and costly at best and deeply unfair or unjust at worst.

A selection among the many colorful examples:

• The wide and perplexing range of prison sentences imposed for the same crimes by different judges, or even by the same judge.
• The amount of disagreement among diagnostic physicians, assessing the same case.
• The high-low spread of insurance premiums quoted by different underwriters for identical risks.
• The divergence of “expert” predictions on future events, from movie sales to interest rates to election outcomes.

The authors bring several surprises – one, that although decision-makers have been frustrated by the degree of noisy variability, they have not (until now) treated it as a subject for identification, analysis and pursuit of responses.

Another, the commonality of noise-inducing conditions across multiple environments:

• Single decisions are as much infected by noise as those that are repetitive or frequent.
• Individuals and groups or teams are similarly susceptible.
• Noise is no less present in predictive decisions whose future outcomes are unknowable, as in choices where simple research or fact-checking would have been relevant and valuable.

The authors readily recognize that variability in judgments is often desirable. Diversity of creative approaches and contrarian opinions are important across fields from film making to market making. But while diversity of views may benefit entrepreneurship and risk taking, it is detrimental elsewhere. If two doctors disagree on a diagnosis, at least one of them is wrong; errors in underwriting do not cancel or average out, but are cumulative; it does not inspire confidence that a job offer or a performance evaluation can be skewed by the time of day it is decided.

Space allows only a sampling of the authors’ analytic taxonomy:

• System noise is broken down between level noise – the variability of judgments due to process ambiguities – and pattern noise – differences in results based on the personal predilections of the decision-makers.
• A noise audit is proposed as the starting point for an organization’s systemic commitment to a noise-reduction effort.
• Decision hygiene encompasses noise reduction by analogy to hand washing in a hospital, reducing the presence of errors, even –- like germs -- without their precise identification.

“Noise” commends tailored and specific strategies to address and reduce unwanted variability, recognizing that the balance between the predictability of strict application and enforcement of rigid rules, and the elasticity of general standards at the discretion of an enforcement authority, is fraught with complexity. It is also at pains to recognize the necessity for trade-offs -- two in particular:

First, costs and benefits require evaluation. As an example, difficult as it is to predict the eventual success of newly hired employees, HR decisions can be improved, at least up to a point. Results improve with inputs from multiple interviewers, provided independence is preserved and the process is not subverted by committee influence or the urgings of a vocal advocate, or where sequential evaluations are passed along, so that an early rating takes on undue influence.

Similarly, noise in the grading of student work owes to the vagueness of evaluation criteria and the fatigue factor or even work hours of the grader. Research shows improvement where essays are ranked best-to-weakest –- a technique more dependable than the assignment of individual numeric scores. Having more than one grader reduces variability, although the time and cost are more easily justified for university admissions or graduate theses than for fifth graders.

Second, reduction in unwanted variability can implicate fairness and equity. Criminal sentencing, long and widely criticized as so unpredictable as to be a “lottery,” depends not only on the judge assigned, but also on such seemingly irrational factors as the time of day or day of the week of a sentencing hearing.

Which said, judges themselves and other critics have reacted negatively to rigid sentencing guidelines, with “three strikes” thresholds and mandatory prison terms, as removing discretion to consider extenuating circumstances or the prospects for rehabilitation.  

That challenge was on display at my boarding school, a very long time ago. The slender Students Handbook was simplicity itself. Strict prohibitions were few: curfews were explicit, attendance and punctuality were expected and enforced, alcohol and drugs were banned. Beyond that, judgment was expected. Alumni of those years recall and recite the central but unwritten principle, “There are no rules here – until you break them” – at which point, official wrath was swift, unambiguous, and unappealable.

Modern examples are available. Readers who share my long-running concern for the model by which assurance is provided on the financial statements of the world’s large public companies will know first-hand the impossibility of divining predictability, comparability or certainty from the pronouncements of purported authorities in such areas as accounting and reporting standards and auditor performance quality.

With its attention to the necessity for balancing and trade-offs, “Noise” has a somewhat provisional feel, especially compared with the notorious rigor that characterized the scholarship of team Kahneman/Tversky, who were unwilling to publish until they had tested themselves and their ideas in protracted scrutiny and debate. Instead, freely admitting the uncertainties and acknowledging the difficulty of generalizing across different domains, the authors both warn readers to proceed with caution and skepticism, and make explicit calls for further scholarship.

A message for my graduate students in Risk Management and Decision-Making who are staying in post-classroom contact: add “Noise” to your reading list, along with my other extra-curricular recommendations.

It’s not a summer beach book. But it will be rewarding, as you extend your studies and as your careers take shape.

(To other readers, if interested in the scope and themes of this course –- for questions, or a syllabus or reading list, drop me an email.)

The affectionate dual biography of Kahneman and Tversky by Michael Lewis, “The Undoing Project” (W.W.Norton 2016), includes the former’s simple test and measure of intelligence: the smarter you were, the faster you realized that Tversky was smarter than you. Modified here, for the sympathetic who have already over-come the natural resistance that inhibits best quality decision-making:

The concepts laid out in “Noise” are complex and provocative. The sooner those responsible for consequential decision-making become engaged, the sooner may come valuable changes in areas previously deemed intractable.

 

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Bubble-Wrap Around Sealed Air's Auditor Change -- Punctured by the SEC's Blunt Tool

It's a pleasure to be a guest again at Bloomberg Tax, which on August 25 published my views on this topic, reproduced here with Bloomberg's kind permission:

It’s not disputed. Sealed Air Corporation’s replacement of KPMG with EY for its 2015 audit was corrupt.

The Securities and Exchange Commission so found. In proceedings dated Aug. 2, 2021 (here and here), the agency barred from practice and fined William Stiehl, the company CFO at the heart of the scheme, censured and fined EY $10 million, and imposed fines and practice bars on three of its partners (Paragraph 2):

“EY solicited and obtained from (Stiehl) competitive bid and other confidential documents and information on multiple occasions in an effort to secure the audit engagement.”

Alert to readers: This is not to question whether a selection of professional advisors should be tainted by the abuse of company confidences. It shouldn’t. This is not to defend or condone the conduct involved.

Instead, it is puzzling why the SEC should invoke its creaky, inefficient, and unpredictable rules for auditor independence (Paragraph 3):

“the manner in which EY obtained the engagement would cause a reasonable investor to conclude that EY was not capable of exercising objectivity and impartiality upon becoming (Sealed Air’s) independent auditor….”

The SEC approach was characterized as “weird” by a Bloomberg News columnist on Aug. 3, as he explored the unexceptional notion that auditors share common ground with lawyers, bankers, and other consultants:

“the actual service that these firms provide is basically ‘wise trusted advice,’ and to provide that service you really do need some relationship of personal trust.”

The columnist rightly notes that by opining on their clients’ financial statements, auditors bear a differentiating obligation from other advisors to public companies. Two observations address his perplexity:

First, consistency should matter. Both the misled but honest senior executives and directors of Sealed Air, and later the SEC alike, would have been no less insulted by a selection of lawyers, bankers, underwriters, or other advisors if perverted in the same way.

Second, which follows, the SEC had an available enforcement tool of broad and consistent application. Under its Rule of Practice 102(e)(1)(ii), it has authority to sanction any person in SEC practice, found “to be lacking in character or integrity or to have engaged in unethical or improper professional conduct.”

Full stop. Proceedings under that provision would lie, with analytic consistency, against professionals of any stripe. Putting them all on notice would spike whatever “weirdness” the columnist may find in Sealed Air.

On the flip side, the SEC’s lumbering invocation of the next provision of Rule 102)(e)—subsection (1)(iii)—goes astray, in its assumption that investors gave any importance to the Stiehl/EY machinations. Investor indifference to auditor performance in general is long-standing; the torpor is disturbed only if an outbreak of malfeasance is grave enough to animate the cry, “Where were the auditors?”

Which was not this case. On June 20, 2019, the company’s Form 8-K publicly announced Stiehl’s termination for cause, “relating to the process by which the company selected its independent audit firm for the period beginning with fiscal year 2015, and relating to the independence of that audit firm.”

So informed, the market reaction that day was a modest share price decline, from $43.67 to $41.70—just under $2 per share and less than 5% —on about four times typical volume.

Even that reaction was fleeting. By July 1—seven trading days later—the share price had recovered to $43.61—above which it stayed—while trading volume retreated to prior levels.

Put bluntly—the investor community, to whose interests the SEC is purportedly devoted, took a look for itself at the auditor environment at Sealed Air, yawned wearily, and returned to business as usual.

History provides another example—the Ventas affair of 2016. There, the SEC defined and applied the scope of Rule 102 to a “close personal and romantic relationship” between an audit partner and his client’s CFO—although, as discussed here, a senior agency official’s contemporaneous speech expressed the SEC’s lack of any appetite for rule-making to provide “bright lines and explicit guidance.”

As in Sealed Air, investor indifference to the audit turmoil at Ventas was reflected in its stock price: In the three-month period between the withdrawal of the incumbent auditor and the filing of an amended Form 10-K with the successor’s opinion, the company’s stock price increased by 3%.

In my youth, growing up in an agricultural village, I was schooled by mentors such as my grandfathers—a farmer and a country dentist—that a proper job requires the proper tools. For the SEC to deploy the elusive “principles” of independence in aid of its unhappiness is like weeding a field with a snow shovel, or using a spoon as a toothbrush—it could be tried, but the result would be sub-optimal in both theory and result.

It’s for fuller inquiry another time that the independence principles and rules for auditors—and their ill-formed and unloved offspring, the limitations on scope of practice for audit clients—have outlived whatever value they might once have had. Independence has no demonstrable upside; since the delivery by William Welch Deloitte of the first modern auditor’s opinion in February 1850, no companies, investors, or other sources of capital have aggrandized an auditor as an exemplar in observing the independence rules.

To the contrary, the elaborate machinery by which the “appearance of independence” is applied, regulated, and defended, becomes visible only with negative impact, in the inevitable and unpleasant handful of cases found non-compliant with hindsight.

Corporate reporting is under pressure to expand disclosures under the rubrics of environmental, social, and governance—lately extended to diversity, equity, and inclusion. Auditors will require expanded and diversified skills to offer meaningful and informative assurance. For which, the constraining influence of an archaic and obsolete independence structure is out of place at best.

In that context, the SEC’s awkward and unnecessary approach in the Sealed Air case is unfortunate.

 

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Audit Market Caps in the United Kingdom – The Financial Times Fails a Math Test

 “The Glacial Pace of Audit Reform Needs To Speed Up”

The Financial Times might wish to reconsider this headline, above its editorial of late last week.

Global climate change considered, the metaphor may be more apt than intended, as the likely fate of the world’s glaciers is their tragic and accelerating collapse into muddy puddles amid massive fields of rocky rubbish.

The trope would match the UK government’s belated and sluggish response to the tumult surrounding Big Audit in the post-Carillion era. There are two main efforts in its consultation of this March, “Restoring Trust in Audit and Corporate Governance”: a floundering attempt to construct a legitimate audit regulator to succeed the shambolic Financial Reporting Council, and a single substantive proposal directly applicable to the audit firms -- “managed shared audits” for the FTSE 350 companies –- an unachievable idea that has failed to attract any measurable amount of serious support.  

The FT continues to urge a forced reduction of the Big Four’s dominance of FTSE 350 audits: a cap of 80%, within ten years time –- apparently recalibrating its earlier push for 60%.

For the premier English-language publication addressing business and the capital markets, with “Financial” as its very forename, it falls between perplexity and disappointment that the FT’s support for audit market caps pays no attention to the numbers –- bluntly, that the very structure of Big Audit makes impossible the role that would be thrust upon the unfortunately-described “challenger” audit firms.

The facts matter. Here a summary, using the market capitalization of the FTSE 350 companies as a proxy to measure the demands of personnel and resources required to perform large audit engagements:

First the FTSE 100, whose constituent companies’ total market capitalization is £ 1.814 trillion. Of these, the share of the “challenger” firms is zero. Of the far-smaller companies comprising the FTSE 250, their share is about twenty -- in flux although modestly expanded in the last year to some 9% of the total market capitalization of £ 394.6 billion or some £ 35.5 billion.

Combined across the two indices, the "challengers" hold an audit market share of the FTSE 350 by market capitalization of some 1.6%.

Into that reality, the growth necessary for the “challengers” to reach the 20% target urged by the FT may be measured in two ways:

• Yearly for ten years, they would have to add as clients a book of companies with total capitalization of some £ 41 billion –- more than double the size of their collective total client base today. That’s each and every year.

• Or, as an English major with a calculator can compute, to spread capacity-building gradually over the decade, they would have to achieve a year-on-year compound growth rate of 29%.

To this bleak picture, little needs be added. The underlying reasons why the “challengers” have no growth path on that impossible scale do not implicate performance quality. It’s personnel, expertise, geographic presence, and financial and risk support.[1] The stark numbers themselves tell the story -- it’s not going to happen.

Giving these figures no recognition, the FT presses a set of unlikely premises (all emphasis added):

First, the FT assumes a ten-year process “once the reforms are in place” –- a benchmark unanchored to the unlikely fulfillment of the government’s plans at all. So far there is no evidence of the legislation necessary to transform the FRC –- described by the acerbic Labour MP Rachel Reeves as “toothless and passive” –- while her pungent description might well apply to the government’s own process, given its “glacial” –- not to say backwards –- movement on the basics of populating the FRC’s board of directors and filling the office of chairman.[2]  

Second, the FT urges that smaller-company audits might be “assigned” to the “challengers” –- a prospect inconsistent with the obligation on both auditors and companies that client engagement acceptance be at the mutual judgment and acceptance of each.

Third, the FT describes the Big Four as “themselves split on the best way forward, though none is enthused by the government’s proposal for managed shared audits.” This, while perhaps not reaching the level of misrepresentation, mis-conveys what was more forthrightly surveyed by the FT’s own Michael O’Dwyer on August 15, that the Big Four “have refused to back” the proposal for shared audits.    

As reported by O’Dwyer, their message is clear enough, although if bobbing and weaving were an Olympic sport, the Big Four would be medal contenders: with the candor permissible behind closed doors, the take on shared audits would be somewhere between “no” and “hell no.”

Fairly put, however, the Big Four need not go publicly beyond the perhaps characteristic British euphemism. Given the UK government’s paralysis, their simply expressed distaste for shared audits –- a position held in common with the business community and indeed at least some of the “challengers” –- will adjourn any real confrontation with the impossibility of audit market caps to the arrival of the next global ice age.

Finally and most egregiously, the FT leaps to the position that “a transition period where challengers start to mature and incumbents give up a part of their dominant position is inevitable.”

No –- it is not. Several scenarios, no less unappealing, are at least as likely.

A wager on the more likely to first occur: as between actual achievement by the “challengers” of a 20% market share, or (i) the collapse or failure of one or more of the “challengers,” under the weight of their over-hanging litigation and performance quality issues or otherwise, so that their sector falls below critical mass, or (ii) the disintegration of another of the Big Four, as doomed Arthur Andersen in 2002, which would bring about the total collapse of today’s Big Audit model.  

If offered a voice, the world’s glaciers would opt for relief from the malign effects of human interference. No less, the inability of the editorial writers at the Financial Times to appreciate the actual structure of Big Audit impairs the value of their contribution to the discussion.

 

[1] For the details, please see my blog posts of April 21, 2021 and June 1, 2021, and the extended treatment in my book, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon 2019).

[2] At this writing, the FRC’s interim chair is to leave in October, the full-time post being unfilled for over a year since its last occupancy for a mere eight months, while there are two new arrivals on the board and a second empty board seat (here).

 

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

What – they expected gratitude?

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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

Does anybody really know what time it is?

Does anybody really care?

-- The band Chicago’s debut album, 1969

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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