Re:Balance -- Jim Peterson

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

“Hic Sunt Dragones”

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Where to from here?

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

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

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

 

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

“None of us has a clue.”

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

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

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

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

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

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

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

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

The Grim Reality of the Calculations

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

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

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

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

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

Financial Resources –- Credit, Liquidity, and Insurance

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

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

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

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

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

 

                            Partner Capital                     Cash and equivalents

Deloitte                      £ 256                                       £  608

PwC                              274                                        1,128

EY                                 170                                           385

KPMG                           258                                           465

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Despite Separation, the “Linchpin” Effect

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

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

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

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

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

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

Further to the Attitude of the Regulators

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

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

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

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

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

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

Conclusion

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

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

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

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

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

 

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

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

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

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

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

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

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

The Data Beneath the Fragility Discussion

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

A sampling of the issues that confront a reviewer:

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

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

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

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

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

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

The Separate Case for Big Four Financials

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

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

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

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

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

As for “Audited” Big Four Statements

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

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

And Who’s to Do It?

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

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

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

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

 

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

 

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

 

"Predictions are difficult. Especially about the future.”

      — Attributed to physicist Niels Bohr, or a Danish proverb

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

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

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

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

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

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

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

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

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

A Model of Behavior, and Its Assumptions

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

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

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

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

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

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

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

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

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

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

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

The Data Underlying the Calculations

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

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

 

                     Global Revenue  UK Revenue          UK Profit      

                     US $ billions         £ billions             £ millions

     Deloitte        $ 59.3                   £ 4.9                £ 766

     PwC                50.3                      5.0                 1,213

                                       (UK includes Middle East)

     EY                   45.4                      2.75                 596

     KPMG           32.13                      2.43                 436

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

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

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

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

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

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

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

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

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

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

The Broad Run-Up in Litigation Exposures

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

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

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

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

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

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

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

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

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

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

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

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

Extending the Calculations – From Global to Local

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

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

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

Two preliminary matters:

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

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

The Attitude of the Authorities, and the Realities

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

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

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

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

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

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

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

 Enron and Andersen –- History’s Lesson from 2002

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

At the Country Level

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

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

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

To Complete the Picture

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

These will be taken up in a second installment.

 

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

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

“Fall and Slip” -- The Uncertain Timetable of EY’s Separation

“Sell while you can – You are not for all markets”

             Rosalind to Phebe, “As You Like It” (III,v,60)

Summer holidays are ended, schools are re-opened, the seasons turn. And the waiting continues, with no end in sight, since the news in May of EY CEO Carmine Di Sibio’s plan to separate the global network’s consulting and audit practices into NewCo and AssureCo.

Project Everest’s mountain-top remains shrouded, and Di Sibio has not descended. The timetable is reported to slip through the autumn, and the list becomes longer of issues that could de-rail the project.  

“Waiting” is a culturally familiar device. Interests are focused, and tensions build. In movie Westerns the anxious town-folk wait for John Wayne and the cavalry. Theatre-goers wait for Samuel Beckett’s eponymous Godot. Investors salivate for monthly government statistics. Cult devotees await saviors or, perhaps, an apocalypse.

In mid-August I drew contrasts between the structure and organization of EY and history’s benchmark, the 2001 IPO of Accenture, newly liberated after its divorce from Arthur Andersen’s audit practice –- views that, still hostage to fortune at this writing, will eventually be tested.

This supplement looks further at some of the questions beneath the masses of numbers generated by the hordes of banker/advisors feeding at the trough of the EY project. Reactions to the relevant uncertainties will have multiple impacts: on the entire sector including EY’s competitors around the globe, and –- centrally –- for the EY partners’ career-defining decisions as they assess their professional goals and options.   

For EY partners considering a future with a NewCo consulting firm:

Without the anchor of a legacy audit practice, what are the real prospects for NewCo and the mélange of country-scale consulting practices that last year gathered in some $ 25 billion in revenue? To compete for both work and personnel, NewCo would confront not only the other Big Three and their commitment to continued full-service practices, but also the broad-service consultancies with long and well-established global brands and market presence –- Accenture itself at 2021 revenue of $ 44.5 billion, and the deep pockets of Bain, BCG, and McKinsey -– reportedly offering compensation packages for new MBAs in the US approaching $ 250,000.

For consulting partners on the fence and able to choose between the two:

Considering the fluid and evolving state of the global regulators’ views on the provision of ancillary services to audit clients, is there a preferred choice between jumping to NewCo with its uncertain future, or opting for AssureCo, where client development and service expansion may be constrained in a practice focused on that legacy firm’s book of audit clients?

To illustrate the depth of this question -- the SEC’s March 2022 proposed rule-making on greenhouse gas reporting and assurance, mired as it is in critical comments and political wrangling, still makes clear the agency’s view that the intended assurance would fall within the permissible scope of the statutory auditors. Well and good, except a sourcing question for EY: would it be an appealing career path, for a GHG expert, to accept a practice confined to the portion of the annual audits of AssureCo’s US registered clients, against the opportunities to work across the entire sector?

For audit partners who might choose a future home in AssureCo:

• How would the audit-oriented practice of AssureCo either employ or engage the diverse scope of expertise necessary to carry out the complex audits of global-scale clients?

• • These skills extend to valuation, financial instruments, sustainability of all kinds –- where practitioners may for the sake of their own career ambitions be unwilling to confine themselves within the limits of independent statutory audit.

• • Would an independent GHG expert consider it an appealing engagement to support an AssureCo audit, if obliged to demonstrate SEC-level independence and therefore be forced to foreswear sustainability consulting for that company, whether GHG or otherwise?

• How would AssureCo’s limitations in practice scope respond to the market’s evolving needs for broadened and more complex forms of assurance?

• How would it compete not only with the other Big Three firms, which remain committed to multi-disciplinary practice models, but with the new providers eager to expand especially into the world of Sustainability reporting and assurance?

In addition to the already-mooted issues of liability exposure, pension funding, and retention of experienced staff, these questions are of sleepless-night importance for the EY partners, wherever their current location in the EY global structure. 

For them, the wait must seem endless.   

 

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EY’s Project Everest – A Hill Too Steep to Climb

Guest posted this weekend on Francine McKenna's substack, The Dig -- to which, for the breadth and depth of her topics of interest and relevance, readers here are always referred and invited:

Don’t throw the past away

You might need it some rainy day

Dreams can come true again

When everything old is new again

 -- Peter Allen (1974)

The skeptical half of a half-skeptical world has been waiting for details from Carmine Di Sibio, global chief executive of EY, on Project Everest, by which he proposes to bifurcate EY’s consulting and audit practices into, respectively, NewCo and AssureCo.

Di Sibio and EY Global are advised by Goldman Sachs and JP Morgan; EY UK partners have themselves engaged bankers from Rothschilds; Lazard, Evercore and Mercer are reported to be signed on as well. Others are sure to be announced in at least the US, France and Germany.

The interests of those partner groups are far from aligned either globally or with each other, although buy-in from them all is essential for a deal with global aspirations. Arm-wrestling already under way is certain to intensify –- of which early signals are spilling into public view.   

Among other issues, comes word from the WSJ that the whole deal may be hung up on $10 billion in promised but unfunded pension payouts that could rest primarily on the shoulders of US audit partners, who would live in the much smaller entity after the split.

No surprise then, reporting from inside EY is “that the timeline for a decision on whether to proceed appeared to be slipping,” quoting an unnamed EY partner that its leadership “had ‘underestimated the amount of work required’.”

The business school case is now being written in real time: Di Sibio and his team look to be firmly in the grip of the “planning fallacy” –- simply put, as identified by Daniel Kahneman and Amos Tversky in 1977, it's the the natural human bias towards over-optimism that under-estimates the time, costs and pressures of a complex project.

The consequences can be grave, as projects on a timeline subject to slippage fall further into difficulty at each succeeding slip –- examples include the cascading delays in an airline’s flight schedule, the ten-year $ 100 million over-run of the Sydney opera house, or the multiple escalations in the futile American military effort in Vietnam.

For the nonce, Di Sibio himself projects confidence, if as yet little substance.

His model is plainly the breach between Arthur Andersen and Andersen Consulting (AA and AC), the re-branded emergence of the latter as Accenture as of January 1, 2001, and the success of its IPO that July. Tempting as the saga is for Di Sibio’s Everest-scale ambitions, comparisons suggest caution.

More than usual disclosure -- I was a member of the Arthur Andersen in-house legal group from 1982 to 2001, privileged to benefit from the firm’s unique global structure and to enjoy the profitability of its single worldwide partnership. I was there through the divorce, an outside observer of the Accenture IPO, and a retiree all-too-painfully affected by AA’s complex spin into collapse the next year.

That’s a discussion for another day and outside today’s scope. Today’s elephantine question is whether either proposed EY off-spring has the ability to be globally competitive, along with two questions that are narrower:

• How believable is it that the proposed break-up is done under pressure from the regulators?

• • Not very. The accounting regulators in the US and UK, two of EY’s largest and critically important markets, are more than pre-occupied elsewhere. There is no meaningful pressure beyond the large firms’ optics-driven and non-substantive push for “operational separation” in the UK.

• Is it credible that the EY proposal is not motivated by the pressure of litigation?

• • Nope. EY and its partners today face at least two sets of ominous litigation claims -- “bad case” exposures are in the billions, and either would threaten the viability of the EY local firm in the UK (NMC Health) or Germany (Wirecard), with implications for the cohesion of the entire global network. The existential anxiety of the erstwhile EY partners in a much-reduced, audit-focused AssureCo would be darkly mirrored by the enthusiasm of partners with the option of moving to the consulting-focused NewCo to be free of these and other legal claims and exposures.  

Post its 2000 consulting split off to Cap Gemini, EY re-grew as an aggregation of separately built and purchased practices and country entities. By comparison, Andersen’s consulting practice had grown organically since the 1950s within its integrated worldwide structure, until the firm reorganized into two separate business units in 1989. AC’s consulting partners, employees and practice delivery capabilities had ten years of globally coherent operating history by the time of the divorce, identified under a single organization and strategy.

In particular, the transparency of the Andersen worldwide profit-sharing model -- long in place, uniformly applied and agreed by all its partners -- allowed for evaluations and compensation comparisons between and among partners across all lines and borders. 

As a consequence, when the arbitration was commenced in 1997, leading to the August 7, 2000, ruling, the infrastructure was fully in place –- for better or worse, depending on individual perspective. All participants in the entire Andersen partnership knew where they fit, and how they were valued and paid. However distasteful the separation proceedings were, they served to manage –- indeed, to finesse and avoid –- questions or issues of individual loyalty, identification, or opportunity, all of which had been previously addressed.

Moreover, the arbitrator’s award in effect settled two key matters at a stroke:

• First, it set the consultants’ exit price -- $ 1.2 billion, paid by AC to AA –- eliminating any negotiating opportunity for the AA partners, or any further access to whatever value inhered in the freshly-organized consulting venture –- a value handsomely redounding to the AC partners as the new shareholders of Accenture.

• Second, it firmly lodged the issue of partner pensions, evidently the cause of some disturbance among the EY interests, directly as the separate responsibilities of the two newly-defined businesses.   

To Di Sibio, the “success bias” of Accenture as a benchmark would be both unavoidable and irresistible. Accenture’s revenues have grown in twenty years from $ 10.8 billion to $ 50.5 billion, while its initial offering price of $ 14.50, peaking last December above $ 415, still remains above $ 300. The AC partners received Accenture stock with an average post-IPO value of $ 4.8 million each, with added sweeteners in the form of accelerated distributions of pre-IPO partnership earnings and re-payment of their previously paid-in partnership capital.

The picture was of course very different on AA’s audit side. Bereft of the consultants’ revenue and profitability, Arthur Andersen spun into disintegration less than a year later –- with financial damage reaching well into seven figures across its partnership by way of lost profits, evaporated capital, and dissolved retirement expectations.

As for EY’s Project Everest today, fully 2,000 people are said to be beavering away on such questions as these:

• Who goes to NewCo?
• Who stays at AssureCo?
• What are the incentives?
• What about the outside alternatives?
• Who has the scope, the wisdom, and the power to make and enforce decisions that will persuade and secure the votes of individual partners in separate local firms that span 150 countries, whose career-shaping decisions will have personal impacts measured in the millions?

Centrally, what ownership or benefits if any can partners in AssureCo have in NewCo, either before or after an IPO? Considering the accountants’ rules and constraints on independence, the apparent answer is “none.” What price then makes it worthwhile for EY’s audit partners to remain housed in AssureCo, an enterprise reduced in capabilities and capital resources, with global revenue shrunk from $ 40 to perhaps $ 18 billion? Do the partners have the strength and the savvy to pull together, negotiate, and then to vote to accept another break?

The culmination of the Andersen break-up was consequential for both sets of its partners: for those in the Accenture family, a major leap in immediate personal wealth -- for those left in the legacy practice, a wounded organization, a damaged ethos, and a rapid decline into collapse.

For the EY partners now facing their choices, the question of “what to wish for” must loom large, while the longer the process takes, the less likely its achievement. To outside observers, the plausible outcomes of Project Everest include either a break-down and failure of the entire deal, for reasons including those sketched here, or a globally patchy and uneven transaction that pleases nobody -- either of which would risk an unfortunate further weakening of the entire Big Four model itself. 

 

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Ave Atque Vale: What I Learned by Riding in John’s Old Jeep

I am hurting at the loss of a dear friend. John was large in girth, spirit and personality, and his death leaves a hole in my heart.  

Make of this what you will, readers who believe in transcendent energy connections or that nothing is accidental or coincidence: while digging this weekend in the disorder of my files, I turned up a pencil draft, two decades old.  

Here are those old notes, with little change, in salute and farewell to my friend, who would grasp the lesson I took from riding around in his world.

 

I made a recent visit to the car culture of Los Angeles, and came away with an increased appreciation for the value of small and subtle sources of knowledge and expertise –- which need not be complex or exotic to be valuable, only focused and specific. 

My friend John might have been typical in southern California, although to this taxi-dependent resident of an Eastern city, his freeway life was as foreign as his garage was full: matching Porsche 911s as the couple’s separate commuting cars, a sizable Mercedes sedan to haul the luggage for weekends in the country, a marshmallow-shaped Plymouth coupe that went back to his boyhood, and a baby-blue MGB soft-top nestled in the corner, so cute you wanted to pat its rear as you walked by.  

There was also his go-shopping vehicle, in which we set off for wine and other weekend necessities -– a civilian version of the English-built WWII jeep, vintage late 1940s. Right-hand drive, olive-drab, canvas roof and otherwise open to the elements. Its short wheel base made the kidney-thumping ride hellishly uncomfortable.

Parked at a busy market, it attracted stares. I was puzzled. “How do you lock it? Isn’t it an inviting target?”

I was met by scoffs. John did not suffer fools.

“Not another person in all of LA County could get it out of the parking lot. First, there’s no ignition key. A thief wouldn’t know about the off/on toggle under the dash. And the ignition is separate, with a starter switch on the floor above the accelerator.”

I had visions of early lessons on the farm trucks and tractors of my rural youth. To drive the hay fields and the feed lots required a contortionist’s flexibility to manage a foot-activated starter tucked up obscurely between the two main pedals.

“The shifter is floor-mounted under the driver’s left hand. There’s no chance an American could find the R in the pattern. It’s the same lay-out as in this country, just like the pedals, but a Yank would think ‘mirror image,’ hit 2^nd gear, and lurch right into the curb.”

“Last, the old crash-box transmission. If a thief did manage to get out of the parking space, he’d be stuck in low gear and stall within twenty yards.”

There are times to believe in the “wisdom of crowds.” But the instincts of the herd only serve for conventionally available knowledge and experience. The advantages of small information gaps open up when nobody else has the facts.

Put another way, a model based on commodity-scale knowledge has weaknesses that create opportunities in either of two ways: first, because everybody wrongly thinks they know it -– like the dubious worth of bitcoin or a no-advantage business plan -- second, having a unique niche, as with an armor-plated portfolio of intellectual property, or a unique license, or as here, a foreign post-war jeep.   

Neither need it be complicated. British soldiers were trained and knew exactly how to handle the simplicity of their camo-decorated workhorse. In America, John’s jeep was fully theft-proof, for reasons as hidden in plain sight as its inscrutable old technology.  

 

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Auditors Cheating on Ethics Exams – Who’s Surprised?

It's my pleasure to offer this guest post on the substack of my friend Francine McKenna, with her added annotations, at The Dig -- to which readers here are referred and invited.

 

“The past is never dead. It’s not even past.”

           -- William Faulkner

Pious dissections of the SEC’s record-setting $ 100 million fine levied this summer against EY for widespread staff cheating on ethics and other exams, and the firm’s delays and mis-directions in its regulatory reporting, have missed three points:

• They did it because they could, and had their reasons.

• The reasons evaded the understanding and best intentions of leadership, so compliance efforts were bound to fall short.

• Those reasons are based on pervasive human characteristics, shared by members of the accounting profession with the general population.

On the heels of the agency’s 2019 fine of $ 50 million for KPMG’s not dissimilar behavior, how did things go so wrong? How could there not have been a learning effect?

Finger-pointing and calls for accountability will lie elsewhere –- not here –- because the basic reasons lie in human nature, and are not complex. It’s the harder challenge, to reduce the predictable cases of future failure.

With career-long scrutiny of financial and professional break-down and misfeasance, I teach a course in business and law schools that explores the reasons for bad decisions and behaviors. There is a core theme in the shortcomings of the supposed “smart guys” –- whether in the credit crisis of 2007-2008, the halting and inconsistent reactions to the COVID pandemic, the recurrent scandals from Enron to Wirecard, or the persistent outbreaks that, every time, trigger the familiar cry, “Where were the auditors?”

Namely, as fallible humans, all of us are prone to the quick and instinctive decisions that activated “fight or flight” for our primitive ancestors whose DNA we inherit –- good enough to safeguard a pre-historic tribe, but ill-suited to the complexities of modern life, where through bias and error we are led to undesirable judgments and decisions.

A note on resources -- a body of research and literature both broad and extensive. The seminal scholarship is the concise and much-cited 1974 essay of Daniel Kahneman and Amos Tversky, “Judgment Under Uncertainty: Heuristics and Biases.” Kahneman’s “Thinking, Fast and Slow”(2011) brought the themes forward. Applications to policy-setting and personal choices are examined, e.g., in Richard Thaler and Cass Sunstein’s “Nudge”(2008) and Thaler’s “Misbehaving: The Making of Behavioral Economics”(2015).

As context for this latest outbreak of test-cheating, the entire model for financial information assurance, designed in the Victorian era and largely unevolved since, has yet to recognize and apply a half-century of insightful scholarship into the complexities of human behavior. Instead, the accounting profession has contributed to a public expectation of auditor performance that exceeds its failure-avoidance capabilities, eliding the inevitable break-downs that inhere in any complex system of human design and operation.

The themes have specific application to the errant test-takers. However well-schooled they may have been in the standards and literature in judgment, independence and skepticism, fresh university graduates newly arriving to the profession have basic DNA no different –- for better or worse –- than their peers elsewhere. Although sporting a new appliqué -- CPA -- in real-world practice they are not bestowed with any special aptitude for skepticism beyond the normal, nor a super-human capacity to overcome the universal susceptibility to non-benign influence.

In short, no amount of on-the-job training can eliminate the impairing effect of compromising influences -- the stresses of budgets and workloads, peer pressures, or “go along” signals from their immediate supervisors.      

Which means that staff personnel in the audit firms will pursue their interests under the most immediate incentives, in spite of and over-riding whatever earnest and sincere exhortations may come down from on high.

Because there will be cheaters in any human-run system, the search in the current exam-gaming context should turn to affirmative support for failure reduction. Checks and barriers should be inserted; misbehavior and non-compliance should be made as difficult as possible.

That means invoking the authorities in testing integrity. Far be it from my limitations as a late arrival to academia, but two examples: I have used plagiarism detectors, and experienced a law school that required annual instructor certification that all exam questions were unique and not repeated from prior years.

Because mis-aligned incentives and skewed decisional influences are ubiquitous in society’s institutions, they no less pervade the entire ethos of the accountants’ world. The stage for misbehavior is always set.

The refreshed examples of questionable performance reflect the auditors’ too often ill-fated client-oriented decisions, under the most salient if undesirable influences; skepticism, conservative judgments and challenges to clients are subjected to powerful influences including over-confidence, success bias and management pressure.

Broadly speaking, the profession’s limited grasp that these behavioral principles are pervasive is seen in its two defensive messages –- that the vast majority of its personnel act in complete honesty and good faith, and that most of its audit engagements are carried out in conformity with standards and expectations.

True enough, but insufficient and unresponsive to the ubiquity of the exceptions –- small in number but enormous in their consequences –- reflecting, in effect, the inability to grasp the implied downside in the ineffective messaging, as captured in the simple truth, often delivered to unruly adolescents: “When you do good, nobody remembers. When you do bad, nobody forgets.”  

Fortunately, opportunities for improved risk assessment and mitigation are readily at hand. Effective strategy and tactics for business and professional leaders would start with the acknowledgement that much of high-level standards, regulation and guidance falls somewhere between wasted and futile.

• The fiasco at the 2017 Academy Awards was avoidable, by which the presenters announced the wrong Best Picture because the PwC partner carried two envelopes and handed over the wrong one under the distraction of a selfie. Break-down of the flawed no-phones-on-stage policy, observed in the partner’s breach, would have been avoided by a simple requirement that a monitor confirm he was empty-handed before handing him the next envelop.

To be sure, trade-offs of cost and resources inhere in choices about policy enforcement and society’s acceptable level of tolerance for deviant behavior:

• The carnage of teenage drunken driving could be dramatically reduced by two simple if draconian steps –- raising to age thirty the threshold for a license, and immediate mandatory ten-year prison sentences for violators –- neither of which society would tolerate.

• Mass shootings, likewise, would be considerably less likely under a prohibition on civilian possession of assault weapons and severe controls on access to ammunition –- achievable in theory but tragically not in American practice.

Returning to the accountants, there are multiple implications:

• The prospect that a re-setting of the bar for auditor performance may dilute the auditors’ claims for professional status.

• The potential that unresolved continuation of performance quality issues may lead to public withdrawal of the credibility given to the profession.

• Broadened demand for new and evolved forms of assurance may attract new suppliers with fields of expertise beyond the ability of the accountants to evolve and adapt.

The dialog on these is for another time. As for the present case -- recent events have shown that zero defects in ethics testing did not follow from a fine of $ 50 million, even with associated prosecutions of the principal violators. Neither will $ 100 million suffice. The pace of human evolution is not so responsive.

Which does not counsel either cynicism or despair. Instead it’s a challenge that calls for strategies that are better informed and designed.   

 

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UK Audit Reform: Seeing Past The Government’s Blinkers

Part Two –- to extend my June 6 look at the inability of the UK government to advance anything constructive on the troubled state of Big Audit, by which the large accounting networks provide assurance on the financial information of the world’s global companies.

The context is the May 31 release by Kwasi Kwarteng, Secretary of State for Business, Energy and Industrial Strategy, of the official Response to the Government’s consultative White Paper of March 2021, “Restoring Trust in Audit and Corporate Governance.”

As summarized -- and treated in detail in my 2019 book, “DOA: Can Big Audit Survive the UK Regulators” -- while only two topics in the Response’s 197 pages directly address auditor performance, neither can achieve positive change -- not the pending “operational separation” of Big Four audit and consulting practices, nor the proposal to mandate the intrusion of the smaller challenger firms into the audits of FTSE 350 companies by way of direct succession or “mandated shared audits.”  

There must be more to the Government’s blinkered myopia, and the visible limitations on its official comprehension, than the paralysis and diversion of energy inflicted by Boris Johnson’s self-defeating struggle to assert his leadership, or even to survive in office after his party’s weakly expressed “vote of confidence” on June 6 by 211 to 148.

The Government’s Response either avoids, discounts or is often in error. Its lack of vision and aspiration will, unless relieved, continue to hobble any chance of beneficial evolution.

Put another way, public and explicit acknowledgement of at least these is necessary:

• The Government simply has no tools –- authority, magic wand or otherwise -- by which the challenger firms can be made competitive at the scale of the FTSE 350, for want of scope, resources and risk capability.

Which means, whether the critics are happy or not, that no substantive change is achievable that is not based and built upon the resources and the viability of the Big Four.

• Policy or enforcement activities with an intent or effect to “break up the Big Four” would result in a market structure that would be smaller, weaker, and less well equipped to serve the needs of today’s capital markets.

Policies instead should support the broadening, not the narrowing, of both the profession’s endorsed scope of activities and the capabilities of the firms themselves, as contemplated in Sir Donald Brydon’s December 2019 report calling for recognition of the “corporate auditor.”

• “Audit only” firms would be fundamentally weakened, if stripped of their ability to own, manage and deploy the ancillary competencies necessary to audit global-scale enterprises.

Which means that any Big Four separation of their audit and consulting practices –- as recently ascribed to both EY and Deloitte –- would not bode well, as putting at risk both their stability and the value of the current model.

• The public’s basic if mis-guided expectation, that the auditor’s “true and fair view” opinion is protection against loss of investment value, is unachievable at the level of “zero defects” audit quality.

Which means that so long as legal regimes for auditor liability admit the possibility of litigation judgements beyond the financial resources and structural capability of the large firms, a possible Andersen-style disintegration of another large network and the consequent collapse of the entire model cannot be discounted.

• The notion that the disintegration of a Big Four network under terminal litigation or other threat could be rescued by official attention is a feeble and dangerous distraction.

To the contrary, regulators and politicians alike lack both the tools and the agility to forestall another break-up on the scale of Andersen’s precipitous fall in the early months of 2002.

Modest credit given, as modestly due, the Government’s Response did avoid falling into the rabbit holes of the profession’s most rabid critics, on such clear non-starters as criminal penalties, forced legal separation of practices, or government assignment or even take-over of audit engagements.

In all, however, and well recognizing the legitimacy of the public concerns for the fitness of the current Big Audit model, an official perspective that does not acknowledge and address the significant matters passed over by the Response amounts to no more than the unfounded hope that the status quo will not be disturbed over the office tenure of the incumbents.

Such an attitude is not worthy to qualify as a program for change.

 

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UK Audit Reform: The Boris Johnson Government Flies A White Flag

Fifteen long months after launching its consultative White Paper, “Restoring Trust in Audit and Corporate Governance, the UK government of Boris Johnson has surrendered on the “audit “ portion.

That’s on reading the Response of May 31, 2022, from Kwasi Kwarteng, Secretary of State for Business, Energy and Industrial Strategy.

His Ministerial Foreward promises “ambitious plans to further strengthen the UK’s audit and corporate governance framework” (p.3). But a slog through its 197 pages reveals a mélange of delay, retreat, and withdrawal.

Four years and counting after the January 2018 collapse of Carillion that triggered this latest spasm of public dissatisfaction with the functioning of Big Audit, the Response devotes massive verbiage to corporate governance, but a mere nine pages to the only two topics with direct bearing on the performance of large-company audits.

Even for the former, the Response natters on, its proposals reflecting a “built-in scope for fine tuning” (p.4) that is euphemistic for “who knows what may work, or what the unintended consequences may be.”

Readers are largely left to speculate –- generously assuming that Johnson can stay in office in the face of a dramatic loss of confidence in his leadership -- on the particulars that may be expected in possible legislation to be put to an unspecified future session of Parliament, by way of possible legislation to replace the discredited Financial Reporting Council as the profession’s regulator with a new Audit, Reporting and Governance Authority.

Among the multiple examples of what the ICAEW generously called on May 31 a “half-hearted” Response:

• The absence of Sarbanes/Oxley-style corporate reporting and assurance on internal controls (§2.1.27).
• The absence in the new proposal for a corporate Resilience Statement of a similar statement by statutory auditors (§3).
• Leaving for the market the consideration of widened financial information assurance (§6.1.48).
• The absence of commitment to the new qualification of “corporate auditor,” as proposed in Sir Donald Brydon’s December 2019 report (§6.1.48-49).
• Leaving with the accountancy bodies the consideration of auditor training, qualification and skills (§6.1.54).
• Explicitly taking a “wait and see” view on the intractable problems with fraud detection and prevention (§6.2.16).
• Passing entirely on the existential threat posed under the existing regime for auditor liability (§6.1.70).

On the lesser topic bearing on the audit firms –- “operational separation” of Big Four audit and consulting (§8.2) -– the air has long since gone out of any energy for further change; authorizing ARGA to legislate on what is already in process would be inconsequential.  

On the second -- competition, market share and auditor choice -- the Response would inject the challenger firms into FTSE 350 audits by legislating ARGA’s power to set the terms: the percentage of a FTSE 350 audit to be performed by a challenger firm (§8.1.16), definitional metrics (§8.1.17), international reach (§8.1.18), and exceptions for the unavailability of a challenger (§8.1.19).

Importantly, such steps would phase in only over the ten years of the audit tender cycle under §C.3.7 of the FRC’s Corporate Governance Code (§8.1.2). Big Four dominance of FTSE 350 audits not having budged in the nine years since imposition of that requirement, however, suggests the passage of another decade over which evidence might emerge of market share changes perhaps supporting an enforced market share cap (§8.1.15 and §8.1.20).

The necessary conclusion -- implicit in the Government’s comprehensive passivity, and in the Secretary’s explicit readiness to “(set) market participants the challenge of shaping their own future” (p.4) -- is that developments over the next generation will be shaped by already evident market dynamics:

First, KPMG’s announcement of an intent to carry out a cull of its client list, if taken seriously, could open challenger opportunities, if only:

• To the extent its Big Four colleagues were to stand aside voluntarily in the tender process.
• Subject to the challengers’ resource development, risk appetite, and survival in the face of litigation and regulatory exposures.

Second, the roaring enthusiasm for extended corporate reporting and assurance on “Sustainability,” the catch-all adopted by the newly-launched International Sustainability Standards Board, has potential. Whether the advocates are rushing headlong toward a promised land of opportunity or a cliff-edge of disaster remains to be seen, however; there are such overhanging and unresolved issues as the extent of convergence of “standards,” the permissible scope and structure of the audit firms’ ESG resources and practices, and the impact of the litigation and regulatory exposures for which the SEC’s recent enforcement actions in America for ESG reporting deficiencies by both Vale and BNY Mellon are canaries in the mine.

Last, potentially most significant and least appreciated is the very viability of the large-firm assurance franchise itself –- now brought to the fore with the news of EY’s consideration of a global separation of its audit and consulting practices.   

Not for now to ponder pro’s and con’s -- the challenges facing CEO Carmine Di Sibio and his global team are dire. The prospects should not be minimized that the outcome –- rather than a clean global split with all pieces intact and a handsomely-financed windfall for at least some groups of EY partners –- may instead be the exposure of an organization riven with anxieties and antagonisms, ill-equipped for the stresses of publicly-visible divorce proceedings.

Arthur Andersen’s unhappy history is this movie’s prequel. Briefly put, EY’s leaders have put the entire enterprise into play, with the potential that critical numbers of partners in country firms and practices may opt to serve their local and personal interests.

Should that happen, the Government Response to the question of large-firm viability -- that “to provide ARGA with the ability to operate a market share cap in the event of the failure of a major audit firm” would be “intended to give the regulator the ability to react quickly and to limit further concentration in the FTSE 350 audit market in the event of firm failure” (§8.3.23) –- would be exposed as an empty and meaningless charade.

The environment of another large-network disintegration should instead recall the late William McDonough, preparing to step down as chairman of the American PCAOB in the fall of 2005, with his warning -- never since modified or disavowed by any of the profession’s regulators -- that “none of us has a clue what to do if one of the Big Four failed.”

In which case, the irrelevance of the Government’s Response will be well and truly evident. For readers with the fortitude to follow this dreary story, there will be reason for another installment, for this look:

At the level of energy, vision and intelligence brought by the Government to this highly relevant set of issues for the capital markets, its flaccid Response is probably the best it has the capability to deliver.   

 

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UK Audit Reform: Carson Block Comes Up Short

Since the collapse of Carillion in January 2108, there is no remaining dispute on the desirability of extensive re-engineering of Big Audit –- the model by which assurance is provided on the financial information issued by the world’s large public companies.

That said, the discussion was not advanced by short seller Carson Block, who in the Financial Times for May 20 re-played the too-familiar proposition that “the audit industry is failing to protect investors and employees from malfeasance.”

Right message. As for the messenger … not so. The reasoning is deficient, to be explained shortly, but first recognize the anomaly of criticism from someone with deep self-interest in preserving the current model.

Leave for others the impassioned views on the legitimacy –- indeed, the morality –- of short selling. Rather, Block’s arguing for accounting and audit reform is like a whisky salesman arguing for prohibition. The success and very business model of his hedge fund Muddy Waters Capital depend on the ability to dig out and exploit the undiscovered misbehaviours that lurk in the dark niches of corporate reporting.

From his reputation-building attack on Sino-Forest in 2011, down through NMC in 2019 and GSX and Luckin Coffee in 2020 –- all could have been non-events, in the capital markets and for Block himself, if only detected and mitigated on a timely basis, under a model not beset with systemic dysfunctionality.

Nor is there anything new here. Short sellers and their brethren have long been active in the gaps and inadequacies in Big Audit. My own first experience with the world of white-collar financial criminality goes back to 1973, and the Ponzi scheme at Los Angeles-based Equity Funding, exposed by renegade analyst Raymond Dirks rather than by dual auditors Haskins & Sells and Seidman & Seidman.

Beneficial for investors and the entire market structure as would be timely prevention of the malfeasance that inheres in a system populated by those ready to exploit its weaknesses, achievement of real improvement would come at the cost to Block of the very feedstock for his success –- even as that virtuous environment is nearly impossible to imagine in a world where public expectations are of “zero defects” in the operation of a complex system designed and run by fallible human beings. 

Passing the question of Block’s credibility as a critic, his views have these flaws:

First, it is incorrect that “material accountability” for lapses in audit quality is enabled by the “ringfencing of liability.” The market facts are to the contrary.

True, a “worst case” civil or regulatory outcome in, for example, Wirecard in Germany, or NMC, Carillion or Patisserie Valerie in the UK, would be fatal to the financial viability of the local firm of a global network. From there, however, cross-border or global network-level liability becomes irrelevant. The fragility of the global networks was demonstrated in 2002, with the unwillingness of the ex-US firms of Arthur Andersen to support its US firm under the liability of Enron –- thus not a consequence but a major contributing cause of its disintegration.  

Second, Block rings again the long-heard theme that consulting services are “the most insidious way that the audit firms abuse public trust,” advancing the notion that auditors are exploited to “whitewash” business problems.

Which is simply not so -- recent examples to the contrary being the revelations at Wirecard and Adler in Germany, where auditor activity beyond their statutory remits figured prominently. Moreover, the case for broadened rather than narrowed auditor competencies and services, laid out in Sir Donald Brydon’s comprehensive if regrettably side-lined report of December 2019, is now at the forefront of the energized public calls for expanded reporting and assurance in the Environmental, Social and Governance space. 

Least appealing in his whinging is Block’s failure to offer constructive suggestions. The evolution to an achievable and sustainable Big Audit model, assuming resolution of all the necessary challenges, will not sprout and blossom if watered by the crocodile tears of those whose interests are served by the preservation of the status quo.   

Nor, it must be said in conclusion and agreement with Block’s opening shot at the official “failure actually to do anything” on audit reform, is there any credible explanation for the Boris Johnson government’s silence, now running from the March 2021 launch of its fully-informed consultation, other than the bare state of its empty tool kit.   

For that, it is well past time to acknowledge that “operational separation” of the Big Four audit practices is no more than an exercise in optics and appearances, while the forced reduction of their dominant market share of FTSE 350 audits is a “solution” thoroughly discredited as unrealistic and unachievable.

Instead, necessary fundamental changes will require re-visiting of basic principles so long embedded in the model that practitioners and participants can scarcely imagine alternatives –- regarding scope and permissible range of audit practice, extension and diversity of auditor competencies, evolved financial and governance structures for assurance providers, and re-casting of the regimes of regulatory oversight and legal liability.   

 

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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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