Re:Balance -- Jim Peterson

Refuge from the Storm – Seeking Shelter in Troubling Times

 

“… but we must cultivate our garden”

                          - Voltaire’s Candide, 1759

This space has been quieter than usual for a while. As the season approaches for year-end meditation and review, there are two reasons.

First, with the cyclical state of the capital markets somewhere between benign and robust, the critics’ cries of “where were the auditors?” are muted, and the regulators are largely quiescent. Second, in a highly charged political environment that shows no sign of relief, “commentary overload” is real – for both providers and consumers.

So it’s not that I’m withdrawing – far from it. Real issues continue to be worthy of attention. But it’s well to re-calibrate the quantity and quality of information that can be absorbed and processed. 

Taking these in order:

Serious concerns persist, for sure, around Big Audit – the model that provides assurance by global accounting networks on the financial statements of the world’s large companies. That structure only exists and survives because auditors’ opinions are required by the major securities regulators; the uneasy “public/private” relationship traces to the passage in 1933 and 1934 of the foundational American securities laws, although it is threatened at least by these:  

• A litigation impact on the scale of Enron’s collapse in 2001, causing the immediate collapse of Arthur Andersen and reducing the population of firms with the geographic scope and expertise required for global-scale audits down to the critical minimum of the surviving Big Four.

• The accounting profession’s propulsive rush to the forefront with the rapid evolution in corporate recording and reporting on the topics under the expansive rubric of Sustainability, lurching toward the provision of expert independent assurance. That’s despite the unconverged and unready array of “standards” to be applied, and the yawning chasm between the investing public’s unrealistic demand for “zero defects” and the over-estimated performance capability of the aspirant assurance providers. Barring an unlikely outbreak of reflection and prudence, this new “expectations gap” will erupt into an entire new and potentially catastrophic outburst of professional liability exposure and litigation.

• The still-to-be-measured flood of private equity and other third-party capital directed at and eagerly embraced by firms in the tier below the Big Four – where uncertainty clouds the impacts:
  • On the personnel side, freshly-funded departures of senior leadership, career and advancement prospects for the next generation, and the questionable appeal of this new model to potential entrants to the profession from the universities.
  • On the service delivery model, the constraining effects of the independence rules that will inhibit the firms’ services to clients of their new third-party investors, and the potential constriction, discontinuance or disposal of their audit practices.
  • On the governance and structural side, the very viability of a multi-disciplinary firm having the breadth of skills and expertise to handle either complex audit engagements or the evolving scope of Sustainability assurance, as the pressures of new investors will incentivize the re-structuring and separation of practice lines deemed insufficiently profitable.

These all being noted, the environment is quiet for the moment. The wave of large litigations extending from the collapse of Carillion in 2018 appears receded, so far without the deadly consequences that their scale initially threatened – although as has been the case for the last half-century, a fresh threat of existential size is as imminent and predictable as the next and inevitable large-scale global scandal.

Meanwhile the regulators in the most significant jurisdictions lie becalmed. The post-Carillion sound and fury in the UK has gone silent, and the impending change of administration in the US augurs a return to the somnolence of its first term.

(With one supportive observation and one exception: The PCAOB just announced the shelving of its deservedly-criticized proposal to re-write the rules on auditor disclosure of client violations of laws and regulations. And its November 21 release, looking to impose a suite of information disclosure requirements on the large firms, is certain never to see final implementation. SEC approval is required, but unlikely to survive chairman Gensler’s resignation announcement the same day and effective in January; at the same time the vigorously dissenting member, Denise Ho, is tipped to become head of the agency in the new administration, which can in any event be expected to return to its first-term state of paralysis and inaction.

(And there is Australia, too distant to be audible or influential above a whisper, where PwC has managed to extend attention to its tax practice’s misuse of confidential government information into the maladroit handling of the political aftermath, providing fuel to a retaliatory slate of proposed “reforms” appearing to be cribbed from those proposed without significant adoption or effect in the UK.)

Last in this area, much ink is spilled over an asserted “pipeline problem” – that is, concern over the volume and quality of potential new entrants – with the youth either declining accounting majors at school, passing on the credential of the CPA or its equivalent, or opting out of practice altogether in favor of careers in consulting or finance.

As for the second of these themes – attention is urgent to the personal challenges of conserving and preserving mental health and emotional well-being. That’s because – with particular focus on the last American election cycle - the approaching new year threatens an extension and expansion of the soul-trying inflictions of the last.

That is, on the losing side, the bubbles inhabited by the politicians and their media enablers continue to look as opaque and resistant as ever to the necessary evolution in vision and messaging that outside influence might bring about.

As the election outcome so resoundingly demonstrated, those most visible and audible up through November 5 comprehensively failed to understand, appreciate or act effectively on the state of the American electorate. Falling so short, to use their own unappealing cliché, in “grasping the Zeitgeist,” they continue to serve up volumes of recriminations, tinfoil-hat conspiracies and outlandish “analysis” from the same tiresome and manifestly unsatisfactory perspectives.

Those are conversations I decline to join. Rather, while reserving the desirability of accessing legitimately reported news, my healthier choice is to forego the sterility of both the op-ed equivalents of toxic junk food and the social and conversational re-hashing by the unqualified of last night’s broadcast sound bites.  

Meanwhile on the other side of the trenches, the near-term future looks to be populated by knee-bending sycophants whose shortcomings in experience and competence are overlain by slavish devotion and ideological fervor. Confidence is not inspired – disruptions and break-downs in major areas of the nation’s political and bureaucratic institutions will quickly emerge under the mismanagement of those too ignorant or too blinkered to appreciate the extent of their “not knowing what they don’t know.”

In this dispiriting environment, under the two-fold influences here outlined, adjustment is indicated. As I have sought over two decades to respect both the patience of my readers and the credibility of my content, I have neither need nor desire to publish for the sake of a timetable or to keep up visibility for its own sake.

Ample opportunities will emerge soon enough, to dial up the energy and re-focus on matters deserving attention. For that, I look for perspective to Candide’s observation, after all the mayhem and violence in Voltaire’s satire - not the counsel of despair, but a call instead for the importance of optimism tempered by experience.

However you may celebrate this turning of the year, then – hug your loved ones, be grateful for your blessings, and keep the faith. 

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

       

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

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

 

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

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

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

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

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

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

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

Those needs are evolving, not going away.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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The Endangered State of EY's Split-Up Strategy

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

 

#1 on Billboard’s Hot 100, August 1962

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Suppose the Proposal Fails

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

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

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

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

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

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

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

Suppose the Deal Succeeds

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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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.”

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

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

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

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

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

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

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

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

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

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

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

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

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

This, then:

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

Under these unhappy conditions, barnyard metaphors are irresistible:

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

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

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

 

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What Price Wrong-Doing? Sanctions Against KPMG Are Complicated

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Failure Study: Can Auditors Get Better?

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

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

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

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

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

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

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

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

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

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

Download CPAJFailureStudy

 

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“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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