Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

 

 

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

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

            -- Gamblers’ maxim

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

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

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

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

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

 

    PwC Deloitte EY  KPMG BDO Grants Mazars RSM

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

This concludes a series on the state of the UK environment, started back in September. Thanks for joining. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both on the Main page.

 

 

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

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

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

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

“Thrown under the bus” would be apt.

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Dominance in the Big Audit Market – Reality Meets Its Critics

"The girls all get prettier at closing time….”

             --Mickey Gilley, 1976 (lyrics by Baker Knight)

A series began here on September 25, to look at the agitation in the United Kingdom around the Big Audit model, and the proposals mooted by regulators, politicians, the government's Secretary of State for Business, and the accountants themselves, by which the dominance of the Big Four would supposedly be addressed.

Proposals include split-up of the Big Four, stripping the firms’ ancillary services to reduce them to “audit only,” joint audits with smaller firms, government assignment of engagements, and voluntary reduction of their 98% share of the FTSE down to 80% or, as urged by the Financial Times on September 2, even as far down as 60%.

That introduction looked at a graphic display of the Big Four’s market share – illustrating the impracticality of this array of so-called “solutions” -- at least so long as the world’s capital markets desire the survival of the current model of privately-provided assurance on the global financial statements of the world’s large companies.

Focus here on the achievability of a market share reduction. The FT on September 2 cited Barclays as a “prize” engagement to be taken up by a smaller firm. So consider the simple question of choice-making, and try to imagine a cohort of civil servants charged to evaluate competing proposals to succeed incumbent KPMG.

Of the total 2017 revenue reported by Barclays PLC for 2017, about two-thirds or some £ 14.4 billion was reported in the non-UK operations of Barclays International, conducted through 40 “main entities” in 22 different countries.    

Assume for the nonce that the Financial Reporting Council achieves a sufficient vote of confidence to survive the pending calls for its abolition or wholesale re-working as the UK’s audit regulator. If it is to be the appointment authority, would its remit run to the UK only? How would it address the global challenge that large UK-based companies derive only some 25% to 30% of their revenue inside the country itself?

Suppose the FRC engineered a UK-only shift of Barclays to a smaller firm – which would face the dazzling complexity that two-thirds of the client's operations are foreign-based and must be audited abroad. What would be the realistic likelihood of successful administration and integration of the multi-country non-UK work if still done by KPMG, into and along with the local reporting on the bank’s UK and headquarters operations?

Or, alternatively, suppose the FRC were bold enough to insist that a smaller firm’s global report and opinion would only be compliant if supported by the work of its own ex-UK member firms. All aside from the political challenges of forcing that decision down the throats of regulators around the globe, there would be the impossible challenges to the smaller firms competing for the job, to demonstrate a satisfactory breadth of geographic presence and expertise.

Of no less importance, the FRC itself would require the competence to scrutinize and compare the qualifications of the small firms and their competing applications, including their relative competence to audit complex international banking operations in countries speaking perhaps nine difference languages and using some fifteen different currencies.

The realistic prospects for the required army of functionaries are non-existent. Examples of dubious regulatory choice-making are all too common, and need not go beyond the current criticism of the FRC itself, to raise doubts about the ability of a government agency to supplant the "auditor choice” function now performed by corporate audit committees in the exercise of their own mandated duties.

On a related front, what is the likelihood of any beneficial impact from an attempted reduction in the Big Four’s dominant market share of the FTSE 350?

To start, what is meant? What metric would apply to measure a reduction to 80%, or 60%?

The FRC might seek to enforce auditor choice based on a financial basis. If so, observe that the FTSE 100 and 250 together have a total market capitalization of £ 2.448 trillion. A 20% shift in market share to the smaller auditors would involve re-assigning a portfolio of companies with aggregate market cap of some £ 490 billion – while a 40% share would involve some £ 979 billion.

The scale issue promptly enters, because corporate size, like that of the accounting firms themselves as graphically displayed, is distributed on a “hockey stick” basis. That is, of the total market capitalization of the entire FTSE 350, it takes only the 70 largest companies to make up 80%, while the companies making up 60% reaches down from BP as the largest only so far as Anglo American at number 25.

Practicality now screams at high volume. For firms outside the Big Four to audit a mooted 20% of the FTSE 350, by market capitalization, they would need to take up the audits of all the index companies smaller than about number 71 – an over-whelming total of some 280 engagements.

Or suppose the FRC were to pursue its goal by number of companies only. To move 20% of the 350 might mean displacement of about 70 audit mandates. Suppose briefly that the choice process would focus on the smaller end of the scale (a topic for further inquiry in any event). The total market capitalization of the 70 companies at the lower end of the index is about £ 60 billion. That, for context, makes up about 2.5% of the index total. To shift that number of engagements, for all the cost and disruption involved, surely has the appearance of a goal not worthy of the effort.

Moreover, audit experience and competence are not fungible across industry sectors. The issues and the demands differ, for example, as between banks and hotels and consumer products. By market cap or simple numeric measures, or any other metric passing a test of rationality, the proponents of the “market share reduction” proposition -- trying with straight faces to sell the notion that either competition or audit quality would be beneficially affected – should be obliged to demonstrate the availability of the resources by which the FRC could hope to carry out its charge, and the smaller firms could hope to achieve and demonstrate anything remotely like the necessary capability.

On both, skeptics are waiting.

Meanwhile this series will continue. Thanks for joining this dialog. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free – both at the Main page.

 

 

 

Re-Work the Big Four Audit Market Share? A Single Graphic Shows "No Way"

Glendower: “I can call spirits from the vasty deep.”

Hotspur: “Why, so can I, or so can any man;
               “But will they come when you do call for them?”

            -- Wm Shakespeare, I Henry IV, iii, 1

Can concerns over the suitability of the Big Audit model be addressed by forcing the large firms to shrink their dominant market share – or any of the other "solutions" mooted in the UK by regulators and politicians?

Abetted by the ICAEW, the Big Four floated last month a readiness to reduce their 97% share of the FTSE 350 to 80%. Not good enough, said the Financial Times on September 2, plumping for 60%.

The last year has seen multiple renewals of the perpetual question, “Where were the auditors?” Colonial Bank – Carillion – Danske – Gupta – Steinhoff – ImdB – the examples circle the globe. In London, hostile critics are circling -- fairly salivating at such notions as breaking up the Big Four, stripping them of their ancillary non-audit services, or nationalizing the selection and assignment of large-company engagements.

A blunt truth, for those desiring to maintain the current model of private assurance on the global financial statements of the world’s large companies: none of these can be achieved in a non-disruptive way, nor would they touch either competition or quality, except to be seriously detrimental to both.

To start what will become a series -- the topic being too complex to cover in a single go – there is the simple matter of scale. This graphic[1] arrays ($ millions) the 23 international accounting networks with 2017 global revenue above $ 200 million – from giants Deloitte and PwC at $ 38.8 and $ 37.7 billion down to the $ 361 and $ 207 million of Asia-based ShineWing and UC&CS of Latin America.

The visual message is simple and stark. No network smaller than the Big Four has a prayer of achieving the scale and resources to clamber into a competitive position.

The importance and impact of scale show a fatal flaw in the “market reduction” proposition -- displayed right there on the familiar but under-appreciated “hockey stick” curve. Other examples abound:

• Earthquake damage: there are countless harmless daily tremors, while the exceedingly rare catastrophes are devastating.

• Book sales: a handful of blockbuster authors – J.K. Rowling, Dan Brown, Bob Woodward – overwhelm both the modestly successful and the long tail of unread dissertations and self-publications.

• Destructive weaponry: the number of nuclear weapons is small but existentially threatening, scaling down from warships and assault helicopters to the local impact of hand-carried firearms, clubs and spears.

Not only does scale matter – its impact is exponential. The two largest of the Big Four are ten times the size of numbers nine and ten – and one hundred times the size of the two at the far right.  

The issue need not assume quality differences. Hosts of talented but struggling and unemployed actors and musicians and athletes wait on tables and hustle ride-shares, while a handful of super-stars get the plum jobs and sign the extravagant deals. In the 16^th century, the small cohorts of Pizarro and Cortés with their Spanish arms, armor and horses subdued the entire Incan and Aztec empires.

On the same core principles -- no amount of best-quality experience auditing community banks and retail brokers and owner-operated corporations can equip any of the thousands of small-network auditors with the credentials, expertise and geographic presence to take on the engagement of a Barclays Bank or a GlaxoSmithKline.

Those examples are cited deliberately. They are urged by the Financial Times as among the “prize mandates,” whose audit committees under a re-engineered model “can as easily appoint an auditor from outside the Big Four as they currently do from within.”

Perhaps not. Shift from the visual to the verbal, with a look at Barclays’s 2017 Country Snapshot. That report, on the global tax position of the UK’s second largest bank by assets and ranked 17th by market capitalization in the FTSE 100, examined and reported on by KPMG, covers 36 countries where the bank’s local turnover ranges from £ 13 billion in the UK down to £ 10 million, plus an additional ten countries below that cut-off.

The scope of KPMG’s tax report, laid out in its footnote, displays the auditor’s obligation to provide holistic global capabilities -- among other matters, to address “which entity to report activity under,” and intra-group eliminations that “include dividend payments, income from intra-group transfers of assets, and income rising from hedging transactions….”

Against those broad needs, an admittedly non-comprehensive sample looked at the publicly-disclosed resources of the four international networks that rank ## 7 through 10, as reported for the ten countries above the Barclays materiality cut-off. Some reasons emerged for possible concern:

• Many of the firms bear the single name or are still under the first-generation leadership of a founder – suggesting at least a question of maturity.

• Several firms disclose that management and service delivery in their locally-listed offices are coordinated regionally or from ex-country locations.

• Of those showing local personnel numbers, a count of five or fewer partners is frequent – several with no more than one or two in the assurance practice.

• And in the disclosures of industry sector or audit practice capability, banking is almost never included.    

Emphasizing again, these challenges take no position on any relationship between size and quality – only that the demands of complex multi-country engagements will outstrip the capabilities of networks locally comprising a small-country client base and limited personnel resources.

Coming installments here will go deeper: the impossibility of nationalizing audit assignments; the fallacy that “joint audit” could be a realistic springboard from which a small firm could vault up to an upper tier FTSE-indexed engagement; and the question, if the Big Four were to surrender clients, just who would choose, and how.

For now, it ought to be clear that neither wishing nor complaining, however loud and passionate, make for achievable policy.

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[1] Source: the International Accounting Bulletin

The PCAOB Proposes a New Five-Year Plan – Excitement Levels are Muted

"Mann Tracht, und Gott Lacht”

            --Yiddish adage

 “Man plans -- and God laughs.” Heavenly company for bemused reactions to the draft five-year Strategic Plan exposed for public comment by the Public Company Accounting Oversight Board on August 10.

The audit regulator in the US is starting afresh. An entire slate of five new Board members was installed in December, ending the two-year extension of chairman Jim Doty’s sell-by date. A sweep of senior staff departures has included the heads of enforcement, registrations and inspection, audit and professional standards, and information technology.

Little wonder the new chairman’s Message touted the engagement of a “strategic planning consultant.” Who else was to help all the new arrivals find their desks?

The results are risibly obvious: page upon page of language so blandly generic as to be taken from available templates or cribbed from those gathering dust in corporate file bins. Mind-deadening language is strewn across an amplitude of numbers:

• Four “areas of strategic focus” in the Message itself
• Four “primary duties” in the description of the agency (p.3)
• Five “values” (p. 4)
• Three “key factors” affecting the strategic outlook (p.5)
• And five “strategic goals,” each bearing between two and four “objectives” (pp. 7-13)

All displayed under cover of five bullets in a press release, to set forth what the Board “intends” – unfortunately omitting any specifics of inter-play amongst them.

It’s a matter of perspective whether issuance of a “plan” that could have come from a desk drawer justifies such a doubtless high-priced exercise. The Board does buy itself the political benefit of a placeholder, as the absence of detail under this top-heavy verbosity will give cover for the time to provide annotations – sure to extend past this fall’s mid-term elections and well toward November 2020. And an approach of “do-nothing, and very slowly” accords with the PCAOB’s long-established tradition of releasing its modest accomplishments only after excruciating periods of contemplation: six years to consider the naming of audit partners, three years before concluding that mandatory auditor rotation was a non-starter, six years to fall in behind the IAASB in requiring extended auditors’ reports, and sixteen years and counting without resolution of its impasse with Chinese authorities over information gathering and audit firm inspections there.

(For entry to a fuller discussion of the PCAOB’s languid history, see my posts of December 21, 2015, February 11, 2014, August 29, 2017, and January 5, 2018, and Chapter Three of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (2d ed. 2017) – here.)

As for the invitation to comment on the Plan and its five Goals, some specific steps might reasonably be slotted into the Board’s aspiration to be “a trusted leader that promotes high quality auditing”:

• At the heart of the PCAOB’s public credibility issues, its objective (1:1) to provide “more timely and relevant feedback” has been frustrated from inception by the lid of confidentiality clamped on the nature and scope of information that is publicly disclosable, under the Sarbanes/Oxley law itself (see Release No. 104-2004-001, August 26, 2004). Unlikely as it would be in the current environment, a legislative initiative to permit real transparency, taken jointly with the leaders of the no-less-reluctant accounting profession itself, would be to the benefit of both. Trust and credibility require no less -- but don’t hold your breath.

• The stated objective (2:1) to “ensure that oversight activities do not impede innovations…” is not met by a plan merely to “monitor the development and implementation of emerging technologies.” Evolution to an assurance function fit for purpose, to supplant the currently low-value “true and fair view” opinion, requires the fundamental elimination of the archaic and detrimental constraints on the scope of ancillary services permissible to auditors. Again – critically necessary, although unlikely.

• To “expand engagement with other audit regulators around the globe” in a meaningful way (3:2) would involve actual advocacy of specific areas of desirable change. By rights this should start by the PCAOB re-visiting with its counter-parts the failure of mandatory re-tender in the UK to avoid the unintended consequence of reduced competition, and the prospect of similarly malign results under the mandatory rotation rules of the EU.

• And, on the other hand, where progress has proved futile and success elusive, namely in China, a strategic retreat is indicated, ahead of the blow-up that is otherwise a present hostage to the antagonisms between the oversight regimes of the two countries.

To close on a non-trivial quibble with the lack of a roadmap to the Plan from the Board’s press release and its five “intents,” no substance is offered on how to “reinforce the PCAOB’s culture of integrity, excellence, effectiveness, collaboration and accountability.”

On that topic, silence from this Board is no surprise, about the long-running criminal proceedings in New York, where ex-agency employees are charged with purloining and transmittal of confidential inspection information. With leadership’s heads firmly down, more impactful than lofty language and process tweaking by the agency is the prospect that the ex-employees are facing potential prison sentences of up to 65 years.

Putting that notion into a “strategic plan” would have suited Voltaire’s 18^th century comment on the state of discipline in the French navy, that hanging the occasional admiral should “encourage the others.”

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Changing the Big Audit Model: Where Might the Regulators Go?

Changing the Big Audit Model: Where Might the Regulators Go?·

 

- Zack Mayo (Richard Gere), “An Officer and a Gentleman” (1982) – standing in for Financial Reporting Council CEO Stephen Haddrill, Competition and Markets Authority Chairman Andrew Tyrie, and parliamentary inquiry leader Sir John Kingman

 In the Federal Deposit Insurance Corp.’s litigation against PwC over its audits of the failed Colonial Bank in Alabama, Judge Barbara Rothstein has loosed a second blast -- her decision of July 2 fixed damages at $ 625 million, for the liability spelled out at length in her decision last December.

Appeals will come, making premature any crystal-ball gazing on the final result. That did not stop a media snowstorm -- a partial sampling included the Wall Street Journal, the Financial Times and the Times of London, Reuters and Bloomberg, Accountancy Age and Compliance Week.

On July 3, Francine McKenna at MarketWatch reckoned this the largest judgment in the U.S. against an auditor – rare as those are, and assuming its ultimate finality. McKenna then shifted her focus from judicial outcomes to negotiated settlements, to round on the practice of protecting settlement figures in private auditor litigation by confidentiality agreements.

She cited as an argument of the firms that settlements should be kept confidential, out of “fear that public awareness of potentially large settlement amounts might undermine confidence in an audit firm’s continued viability and/or prompt clients to abandon it.”

On the basic but seldom-discussed financial fragility of the Big Four networks, her proposition picked up reinforcement from the Times of London on July 9, under the sub-head, “Litigation over a flawed audit could quickly lead to an Arthur Andersen-style collapse.”

This issue should not be new. Starting in 2006 in my “Balance Sheet” column in the late and lamented International Herald Tribune, I have been calculating the litigation “tipping point” that would disintegrate a Big Four firm. Updating, the 2017 edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” estimates those figures today at between four and six billion dollars at the global level and between one and three billion dollars for one of their U.S. firms standing alone – amounts falling somewhere between “modest” and “scary” considering the level of their exposures.

Is McKenna’s supposition of anxiety on the part of the profession that settlement disclosure might undercut public confidence a straw man? Equally arguable would be the benefit of public recognition that the business models of the Big Four – running on their client receivables and paper-thin capital – are simply not robust to withstand the shock of a truly “bad case” litigation or penalty.

If transparency of the large auditors’ financial information does have the virtue for which McKenna argues, an approach perhaps deserving a refreshed airing would be that the large firms publish their own global financial statements.

It’s been done. In the U.K., the FRC’s Audit Firm Governance Code (section E.5, 2016), requires such statements, although on a county-level basis only. And going back to the 1970s, Arthur Andersen made public its global financial statements.

The FRC or the Public Company Accounting Oversight Board in the U.S.could readily craft requirements that would compel such broad disclosure. Audits could even be required, drawing on the Andersen practice that its statements were audited and opined on by Haskins & Sells, as the Deloitte firm in the U.S. was then branded. Such a step would, however, involve a twist both ironic and politically charged, that the only auditors with the scope and scale to report on a Big Four network would be other members of that quartet.

In the pros and cons of that debate, in other words, the critics of the profession who are inclined to see malign cartel behavior under every rock would do well to consider what to wish for.

As for any utility attributable to broad release of settlement information, “public awareness” -- like movie temptress Mae West’s dismissive attitude toward “goodness” -- has nothing to do with it. Competent management and audit committees – as well as any trial counsel with the skills and experience to litigate a ten-figure claim of audit failure – have the information needed to evaluate the soundness of a firm – both absolutely and relative to its peers.

In that calculus, the firms’ litigation exposures and the stability of their finances are further ingredients in an information mix that also includes the virtual lack of auditor replacement choice at the large-company level – a subject front-and-center in the public debate, as witness the three separate inquiries now on-going in London, under remits undertaken by the Financial Reporting Council, the Competition and Markets Authority and the committee instigated by the British parliament.  

The range of possible changes to the Big Audit model being tabled runs from the anodyne to the harmful to the laughably impractical -- “open source” audit software, break-up or spin-off of the Big Four audit practices, or even fixed quotas on a Big Four firm’s book of large clients (see the Times for July 9).

Because the City of London boffins charged to tinker with the UK’s regulatory machinery would think it unseemly to concede the intractability of the issues, Messrs. Haddrill, Tyrie and Kingman may be expected to deliver something. But caution is called for; as the sub-head of the Economist’s May 26 editorial put it, “The audit industry needs fixing. But dismantling the Big Four is not the way to do it.”

As the recent experience with the unintended anti-competitive consequence of the FRC’s requirement for re-tender has shown – namely the withdrawal of the Grant Thornton firm from tendering for FTSE 350 audits – attention by the inquiry trio would be well focused on proposals having both practicality and achievability.

If in the end they manage to do no actual harm, that would deserve to be called success.

 

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• Guest-posted in today’s Going Concern, with thanks and appreciation for the opportunity.

What Next for the Big Four in the UK? London Is Searching

Globalized as the issues challenging the accounting profession have become, London is the current hot-spot, so it was my pleasure this week to offer this guest post for the largely US-based readership of Going Concern – also a chance here to offer my thanks, a major hat-tip and Godspeed to Caleb Newquist as he moves on, and looking forward to working with Jason Bramwell:

 

 A drunk, searching on hands and knees under a street lamp, tells the inquiring police, “I’ve lost my keys – over there in the dark alley.”

“Then why look here?” they ask, perplexed.

“Because the light’s better here.”

In the City of London, where the modern audit profession was born in the Victorian era, no fewer than three separate inquiries have been launched into the business and performance of the dominant Big Four accounting firms and the fitness for purpose of their UK regulator, the Financial Reporting Council.

As for the chances of anything beneficial emerging, instead of detrimental unintended consequences for the stability and viability of Big Audit? There are ample reasons for doubt.

The leaders of the inquiries have set out their stalls, with their aims on full display:

• Stephen Haddrill, CEO of the FRC, put a target on the back of the Big Four in January, telling a parliamentary committee that, “we feel there should be more competition in the major accounting and audit area” – echoed in March in the FRC’s strategic plan (page 7): “As a regulator we cannot be content that just four large firms dominate the market for audit services.”

• Haddrill’s invitation to the Competition and Markets Authority to investigate the prospects that the Big Four should be stripped to “audit only” was taken up with enthusiasm by its new head, Andrew Tyrie, quoted as telling a parliamentary committee that “the ‘competition’ aspect of the Big Four is ‘certainly’ something that needs to be looked at.”

• And the Secretary of State for the Department for Business, Energy and Industrial Strategy has triggered a broad review of the remit, structure and performance of the FRC, under the leadership of Sir John Kingman, whose call for evidence of June 6, 2018, includes as a starting premise in its Foreword that in the Big Audit market “there are well-documented structural competition weaknesses.”

With their opening biases so declared, the approach of all three scape-goating exercises is the familiar “ready … fire … aim” – that is:

• Detailed further admiration of issues long since fully articulated at tedious length.

• Intense and splenetic venting and finger-pointing by the profession’s most ardent critics.

• And re-hashing – and even possible imposition – of “solutions” already examined and found wanting for effectiveness or achievability.  

Focus on these subsidiary areas will at best – and least damaging -- generate bulging records of compelling irrelevance, when such foundational topics should be pursued instead as:

• A broad-based search for consensus on the shared aspirations and goals to be served by a Big Audit function fit for modern purpose.

• Assessment of the barriers to achievement, including candid recognition of the need to re-examine the on-going validity and relevance of long-held beliefs of dubious current value.

• Enlistment of the active involvement of all capital markets participants whose participation and buy-in is necessary.

The prospects do not give cause for optimism. Politicians and regulators are consistent in displaying constraints on their vision, commitment to short-term motion as a substitute for long-term progress, and readiness to apply yesterday’s tools to tomorrow’s problems.

Examples are as close to hand as the negative effect on auditor choice generated by the FRC’s 2012 requirement for mandatory re-tender, leading not to its declared goal of increased competition, but contrarily this March to Grant Thornton’s withdrawal from competing for FTSE 350 audit engagements, or the cascade of American corporate failures in the 2007-2008 financial crisis despite the bally-hooed aspirations of the Sarbanes/Oxley Act of 2002.

Collectively the troika of Messrs. Haddrill, Tyrie and Kingman has potential to run the Big Audit model headlong into the ditch, by driving toward the future with eyes staring fixedly at the road behind. If so the dispiriting prospect is that they might manage perversely to regulate the Big Four firms into a fatal decline to disintegration.

It will take a level of shared vision and skilled diplomacy not often seen in such a complex multi-party setting to avoid such an outcome – much less to reach what might be called success.

 

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The Big Four: Break-Up or Audit Only? Can They Survive the UK Regulators?

“Whining don’t get the hay in” was an article of faith for the family farms of my youth on the prairie of agricultural America. Surviving, alive to plant another year’s crop, required clear-eyed acceptance of the facts as found, and strategies that were realistic and achievable.

 It’s different these days in London, where the model for audits of the world’s large public companies faces a storm of perfervid criticism. The latest is a chapter in the full-throated screed, released on May 16, 2018, by two committees of the British parliament, broadcasting blame far and wide for last January’s collapse of Carillion.

The report (page 85) would refer:

“the statutory audit market to the Competition and Markets Authority. The terms of reference of that review should explicitly include consideration of both breaking up the Big Four into more audit firms, and detaching audit arms from those providing other professional services.”

The MPs link arms with an entire chorus line of the like-minded – the competition authority’s own Andrew Tyrie, CEO Stephen Haddrill of the Financial Reporting Council, and City grandee Sir John Kingman as nominee of government itself – all abetted by the shrill voices of enthusiastic commentators.

What is conveyed in passion, however, is lacking in demonstrated comprehension of the target – that is, recognition of the limited ability of government to act in a benign and beneficial way.

Possibly – and in no way as apologist for the Big Four or their accountability -- well-informed information users in the capital markets may truly desire the continued vitality of the current Big Audit model, and the traditional single “pass/fail” audit opinion on the consolidated financial statements of global companies – although all the qualifiers loaded into that assumption should be taken with deep skepticism.

If so, consider the misguided requirement of mandatory auditor re-tender, imposed by the FRC in 2012, ostensibly for pro-competition reasons. The resulting cost, disruption and continued concentration have instead now driven Grant Thornton, the fifth-ranked firm in the UK, to foreswear future tendering for FTSE 350 audits – joined this week by BDO’s reported readiness to do the same if forced to shed its practice in ancillary non-audit services.

Demonstrably disruptive on the downside, the UK regulators have the power to kill a Big Four firm, or indeed the entire model, through failure to recognize the continued application of the law of unintended consequences. What their limited vision and authority shows no ability to achieve is a positive contribution to the stability of Big Audit.

Splitting up the Big Four in the UK would not only be ineffective on a global scale, because failing to reach the dozens of foreign jurisdictions where 75% of the revenue of UK-based FTSE 100 companies is derived. Neither would such a move add any new competition. Instead, the newly created smaller organs would each be partial in scope and limited in industry expertise and resources, hobbled by formidable cost inefficiencies in re-building duplicative infrastructure, and severely weakened in their financial ability to withstand the shocks of litigation and liability exposures that already threaten the stability and very survival of the Big Four.

As for attempts to force the firms into “audit only” structures, the issues of financial weakening and global impracticality apply no less. More importantly, reverting to the skeptical questions as to the dubious value of the current commodity-valued “pass/fail” report, the rapidly evolving environment of Big Data in all its various permutations means that every element of the assurance model that was invented in and survives anachronistically from the Victorian era will inevitably evolve as well.

Providers of that service in a form fit for future purpose will require precisely the skills residing in the advisory capabilities of the Big Four. And elsewhere, to be sure, which means that deployment by the UK regulators of a “neutron bomb” that would annihilate the Big Four’s ancillary services would achieve only one dramatically consequential result: After several years of sifting through the radioactive rubble of the disintegrated Big Four, new species of assurance providers would evolve from the wreckage, emerging out of the surviving niches and other consultancies capable of building the competencies and expertise to provide value in response to the needs of information users.

Asked in 2005 what he and his fellow regulators would do in the event of another Andersen-like failure, PCAOB chairman William McDonough was candid to say, “None of us has a clue.”

With the current whining, finger pointing and blame mongering that threaten the availability of assurance in the form that users profess to want, McDonough’s reality check remains a cautioning guide.

 

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And for expanded treatment of these themes, please see my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”—summary information is on its Amazon pages in the US and the UK.

 

Should the Big Four Be Broken Up? The Discussion Sharpens

This coming Monday, April 30, London’s Centre for the Study of Financial Innovation is hosting an open public discussion – “The Future of Audit: Break Up or Shape Up?”

I am pleased to have a panelist’s seat.

Details and free sign-up are here. Mid-day timing is convenient – venue in the City at Armourers' Hall – wine and sandwiches served. Media are interested and will be there, but Chatham House Rule. Attendance is invited and welcome -- a lively time is promised.

Here’s the background: In late January Stephen Haddrill, chief executive of the Financial Reporting Council, Britain’s audit regulator, called for investigation of the audit market -- quoted by the Financial Times as telling a parliamentary committee that “we feel there should be more competition in the major accounting and audit area.” He extended his scope on March 16, proposing that “Britain’s Competition and Markets Authority should investigate the case for ‘audit only’ firms in an effort to bolster competition and stamp out conflicts of interest in the sector.”

The FRC’s strategic plan, released in March, doubled down on Haddrill’s advocacy (page 7):

“Competition – or lack of it – at the top end of the audit market remains a serious concern. As a regulator we cannot be content that just four large firms dominate the market for audit services.”

Public attention followed. The Financial Times on March 21 ran a “head-to-head,” in which Natasha Landell-Mills of asset manager Sarasin & Partners and I took opposite sides on a Big Four split-up. The FT published wide-ranging reader reactions, and the CSFI picked up the ball.

Careful moderating may keep the agenda on the rails. In the meantime, the FRC’s positions raise at least two serious issues.

First is the matter of its own record, on which Parliamentary attention has not been kind. The chair of the Commons business committee delivered the charge that the FRC was both “toothless” and “useless,” rounding on its attention to this winter’s collapse of outsourcing company Carillion, and a City grandee, Legal & General chairman Sir John Kingman, has been designated to lead a broad inquiry into the FRC’s performance, operations, governance and operations.

Whether the FRC deserves the epithets will abide Mr. Kingman’s inquiry. Meanwhile my own views are well recorded, that any attempts to split up or strip down the Big Four are doomed as ill-advised and ineffective to address the perceived issues.

Second and directly to the point, it is of no little irony that Mr. Haddrill’s lobbying on competition braced the March announcement by the UK firm of Grant Thornton – by size the fifth in the UK and in the network ranking seventh globally – that it would stop bidding for audit engagements among the FTSE 350, the UK’s large public companies.

On this shrinkage the FRC resoundingly scored an own goal, as the responsibility lies directly with its misguided 2012 requirement that UK public companies put their audits out for re-tender.

The consequences of that empirically unsupported initiative may have been unintended, but they were not unforeseen. As I blogged in August of 2013, while the regulators' timetable for mandatory re-tender was still to be fixed, these results could be expected:

“Mid-tier firms withdrawing from tenders for inability or unwillingness to sustain the impact on their personnel and their business models.

“Further intrusion of the Big Four into the client lists of the mid-tier firms, with resulting increase in the market concentration among that tetrapoly, based on their ability to deploy superior resources against uncertain defenses.”

As we will explore at the April 30 event, any further such tinkering by the FRC is hostage to the global scale on which multi-national audits are undertaken – even as its strategic plan concedes (page 18), “the FRC, like other audit regulators, has no authority over the audit firms’ international networks.”

In looking with concern and skepticism at the viability and sustainability of the current Big Audit model – including in my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – I am not an apologist for the accounting profession or its members, who are legitimately answerable for the quality of their performance.

But if participants in the capital markets are genuinely interested in audits provided by private partnerships that will deliver single reports on the globally consolidated financial statements of their clients – with serious emphasis on the if – then discussion needs to be fact-based and focused on the market realities and the achievability of whatever steps may be offered.

Which said, please join us on the 30^th.

 

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William McDonough: Ave Atque Vale

William McDonough -- president of the New York Federal Reserve Bank (1993 - 2003) and first chairman of the Public Company Accounting Oversight Board (2003 - 2005) -- died on January 22, age 83.

As a regulator he had more success with the banks than with the auditors.

In New York, he saw off the impacts of the Asian credit crisis and the bankruptcy of Long Term Capital Management, and steered the bank through the aftermath of the attacks of September 11, 2001.

In Washington, he oversaw the launch of the PCAOB under the mandate of the Sarbanes/Oxley law of 2002 – the intent of which, as put in its Board’s statement on his passing, was “to restore confidence in public accounting of American corporations.”

The success of that mission will not be debated here. Rather, for my views, see the discussions on my blog, Re:Balance, of the PCAOB’s performance in connection with, e.g., mandatory auditor rotation, independence and scope of service constraints, inspections and enforcement of auditors in China, the naming of lead partners, the incidence of audit deficiencies as observed by regulators, and extended auditors reports – along with comprehensive discussion in my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (Emerald Books, 2^nd edition 2017).

It is all too plain that the PCAOB and its regulatory off-spring spawned around the globe have not succeeded in quelling the periodic and repeated outbreak of large-scale financial disturbances – looking not only at the lengthy roster of failed financial and other institutions during the 2007 - 2008 financial crisis, but down through such recent examples as GE in the US, Carillion in the UK and Steinhoff in South Africa.

In this environment the public cry persists – “Where were the auditors?” – to which the measurable effectiveness and impact of the PCAOB remains as elusive as ever.

McDonough himself had the candor to concede -- when asked by a reporter in 2005 what he and his brethren would do in the event of another collapse on the scale of Enron’s fatal impact on Arthur Andersen -- that, “None of us has a clue what to do if one of the Big Four failed.”

The hazards that threaten the survival of the large accounting firms remain as grave as ever. Mr. McDonough’s terse response hangs in the air – a legacy weighty, ominous and unrebutted.

 

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While Steinhoff Teeters – Did Anyone Care What the Auditors Said?

Myths and fables are replete with urgent early warnings – only occasionally effective. The young shepherd who cried “wolf” -- the little Dutch boy plugging the dike -- the sharp-eyed lad to whom the Emperor was unclothed -- Chicken Little fearing skyfall – all the way back to poor Cassandra, doubly doomed to be disbelieved but proven right.

An emerging large-scale corporate scandal provides a vivid example – sprawling consumer conglomerate Steinhoff International NV, with its global operations based in South Africa, its principal share listing in Frankfurt, and its headquarters in the Netherlands.

As CEO Marcus Jooste put it in resigning on December 5, “I made some big mistakes and have now caused financial loss to many innocent people” – quite an understatement, with the company’s concession of “issues concerning the validity and recoverability of certain Steinhoff Europe balance sheet assets,” reported to reach an eye-popping € 6 billion.

The latest: alleged multi-billion euro accounting irregularities, the company’s share price dropped by 90%, its credit rating cut to junk, predators circling its local operations, politicians and commentators crying for accountability, and rumblings from regulators in the three countries plus the inevitable shareholders’ lawyers.    

In this troubled context, there is this to ponder: Steinhoff’s 2015 financial statements bore the traditional and familiar “pass/fail” auditor’s report, issued by Deloitte’s Pretoria office. The next year, with the change in headquarters, the report by Deloitte’s Amsterdam office ran a full eight pages, over 3800 words with three paragraphs on “materiality” and five “key audit matters.”

Steinhoff thus offers a real-world test of the recent requirements imposed by the major regulators, that investors should receive -- and in theory might actually value -- auditor reports expanded to identify and discuss “critical” or “key” audit matters – see the IAASB’s 2015 International Standards on Auditing, and from the US audit regulator, the Public Company Accounting Review Board, its Auditing Standard on the Auditor’s Report, Docket 034, approved by the SEC on October 23, 2017.

The outgoing chairman of the PCAOB called its new standard “the first significant change to the standard form auditor's report in more than 70 years,” which will “breathe new life into a formulaic reporting model.”

Perhaps – although unlikely. My own skepticism – here – is mainly that the combination of liability anxiety and common if complex issues across companies will mean reversion to boilerplate language of anodyne simplicity.

The Steinhoff situation raises a different issue – namely, does anyone really care?

The United Kingdom is now in its third year of expanded auditor reports. While there has been a good deal of self-congratulation, the world of information users awaits an empirical study of whether extended report language in that country has had any effect on investor behavior – one way or another.

The Steinhoff saga should reinforce the doubts. From September 2015 when Deloitte South Africa issued its short report, the company stock had traded in a fairly narrow and stable range, through a series of large-scale acquisitions. The following year’s expanded report by Deloitte Amsterdam identified as two “key audit matters” the valuation of goodwill and intangible assets of over € 16 billion and the accounting for two major combinations for almost € 3 billion, and its balance sheet showed that long-term interest-bearing loans and liabilities had swelled from € 4.1 to € 7.1 billion – among the "critical" areas where the curious might have inquired for what are now the reported gaping holes.

So Deloitte’s expanded language might have been taken as cautionary. To the contrary, instead, media search fails to locate a single word on its extended opus – whether criticism, credit, or indeed comment of any kind.

Rather, impact if any among the investing public looks over-ridden by the animal spirits of the herd -- perhaps not incidentally including South Africa’s public employee pension scheme, the Public Investment Corporation – who all plunged together right up to this last December, when the bottom fell out and the company’s acknowledged if still unspecified accounting irregularities obliged Deloitte to withdraw its report altogether.

In addition to the apparent indifference of investors, history suggests that the affected legal systems will not be much impressed by protests of “we told you so.”[1]

As the blame-allocation exercise unfolds, it remains to be seen whether expanded auditor reporting will rank in importance at all – or whether defensive assertions will be credible that anyone relied on, or is bound by, the thousands of words by which Deloitte elaborated on the complexity of Steinhoff’s financial reporting.

Will it be shown that any of the expansive auditor verbiage mattered to anyone, more than the typical single paragraphs of audit scope and opinion?

The Dutch themselves would politely say, “vergeet do rest, volledig onnodig” (forget the rest, completely unnecessary). German and South African idioms would be similarly dismissive. The most printable American response would be, “couldn’t care less.”

There will be future developments -- watch this space.

 

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[1] As a model for the less-experienced jurisdictions, the American liability regime has for decades rejected the defense of compliance with professional standards. United States v. Simon (Continental Vending), 425 F.2d 796 (2d Cir., 1969).

“The Chickenshit Club,” Jesse Eisinger (Simon & Schuster 2017)

Jesse Eisinger having conclusively nailed the award for best book title of the year, for his detailed polemical history of the US Department of Justice’s timorous post-Enron retreat from the pursuit of corporate malefactors, it may seem churlish to quibble.

Nor to take away from his dispiriting story’s call for renewed vigor in the prosecution of financial criminality. But from the perspective of fifteen years of scrutinizing Big Audit and the challenges facing the large accounting firms,[1] there are issues at both ends of Eisinger’s narrative – subtle, to be sure -- on which the vigor of his arguments can stand for clarification.

Background, for those who have not yet done the reading (emphasis deliberate): after the convictions of the principals of Enron, WorldCom, Tyco and Adelphia,

“Today’s Department of Justice has lost the will and indeed the ability to go after the highest-ranking corporate wrongdoers…. Prosecutors don’t simply struggle to put executives for “Too Big to Fail” banks in prison. They also cannot hold accountable wrongdoing executives from a gamut of large corporations: from pharmaceuticals, to technology, to large industrial operations, to retail giants” (p. xvii).

His argument bases heavily on the disintegration of Arthur Andersen, Enron’s auditor and the target of the DOJ's wrath for document shredding in the fall of 2001, while the company was collapsing and law enforcement forces were gathering.[2]

Eisinger spins out the 2002 time line of Andersen’s indictment, jury trial and conviction, and cessation of business; the Supreme Court’s 2005 reversal; and the public relations campaign by which Andersen posed itself as the aggrieved victim of government over-reach. As he concludes, Andersen’s “too big/too consequential” arguments failed, but also had no observable collateral consequences:

“The Andersen case ushered in an era of prosecutorial timidity when it came to taking on the largest corporations in America. The response to the financial crisis of 2008, which took down the nation’s largest banks and put the global financial system at risk, stands in contrast to the post-NASDAQ-bubble accounting-fraud emergency…. (F)ear for the fragility of the system dominated the political discourse and tormented Department of Justice officials” (pp. 57-8).

Here’s the first problem. Eisinger is correct, but for the wrong reason, saying that, “The notion that the indictment was solely responsible for putting Andersen out of business is a myth” (p. 54).

In fact, the indictment was irrelevant. Andersen was mortally wounded by Enron, beyond salvation or recovery, simply because it lacked the financial strength and organizational cohesion to withstand the litigation shock.

Enron’s collapse was to be the first case to extract a billion dollars as the responsible auditor’s litigation exit cost. Andersen had that capacity, with its 2001 revenue of $ 9.3 billion -- but barely. It would have teetered on the brink, still facing a crushing load of claims relating to the catalog of scandals that caused Justice to view it as an unrepentant serial recidivist – the sum of which would have swiftly driven it into insolvency.

So -- arguments on both sides of the Enron indictment impact miss the misplaced nature of their premise: Andersen was dead anyway, no matter the policy decisions at Main Justice in Washington. Andersen was like a terminal patient on late-stage life support -- its death was imminent and inevitable; the tortured decision to indict only pulled the respirator plug.

Having strung so much dirty laundry on this fragile line, Eisinger works himself into a righteous froth over the government’s retreat to its pattern of settlements and corporate fines -- all to be absorbed as business costs by the corporate treasuries and shareholders’ equity of the large public corporations -- rather than devoting the time and taking the risks of seeking the higher but less certain rewards of pursuing prosecutions through to trial.

His proposition raises two concerns. The first is narrow, based on the post-Enron structure of the Big Audit model, totally dominated as it is by the surviving Big Four. Here, Eisinger’s bland observation (p. 56) about the absence of effect from Andersen’s collapse – that its “prosecution did not lead to any economic or financial crisis…. Markets didn’t crash (and) corporations just found other auditors” -- fails to meet today’s reality. Which is, loss of another of the surviving quartet would not just reduce the field to a Big Three, but would trip the entire Big Audit franchise into failure.

That’s because the four-firm model is down to a critical minimum. Unlike with the Big Four, there is no supply shortage elsewhere in the professional services sector. The clients of the recently-failed public relations firm Bell Pottinger are relocating without issue, as did those of failed law firm Dewey LeBouef. But as is currently playing out in Japan in the dysfunctional relations between Toshiba and PwC, the range of large-company auditor replacement choices is now too severely constrained to allow any margin for reduction.

So much for the sector. Closing views on Eisinger’s basic premise on criminal accountability start here: outbreaks of financial malfeasance well enough evoke spasms of cathartic retribution. Society calls for the guilty to be punished.

Any longer-term deterrent impact, however, is another matter. That is, cyclical outbreaks of financial excesses inhere in the system and are inevitable,[3] with their attendant criminality, for reasons ranging from the post-event focus of regulators and legislators on fighting the last war, to simple human credulity, greed and rapacity -- embodied in the observation of a legendary New York judge, that “from the time to which the memory of man runneth not to the contrary, the human animal has been filled with cunning and guile.”

It is simply fanciful to think that the next generation of as-yet-undiscovered white-collar successors to the current Martin Shkreli of Turing, Elizabeth Holmes of Theranos or Kweku Adoboldi of UBS will be deterred in the least by the successful but now ancient and forgotten prosecutions of Ken Lay or Jeff Skilling or Andy Fastow – any more than they would by a return to public flogging or transport to Tasmania.

In the rural countryside of my youth, it was considered a measure of perception and good judgment whether a man “had the common sense to tell gravel from chickenshit.”

At the level of fundamental law enforcement policy, that question hangs over Eisinger’s otherwise noble and illuminating work.  

 

[1] Please see my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – here at Amazon, where the “Look Inside” link gives free access to the Contents and Introduction.

[2] Disclosure: after 19 years as a senior member of Andersen’s in-house legal group, I had just left in June 2001, months ahead of the Enron debacle; intensely unpleasant events were to come, but as put by the eponymous ogre in that year’s “Shrek” -- “Better out than in, I always say!”

[3] See, for example, Benoit Mandelbrot’s brilliant “Misbehavior of Markets” (Basic Books 2004, paperback 2006).

 

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