Re:Balance -- Jim Peterson

Crowe Horwath – On The Rocks in China

In the original version of “between a rock and a hard place” -- as Homer tells the story in Book 12 of the Odyssey -- when Odysseus sailed for home through the narrow straits between Scylla the six-headed monster and the deadly whirlpool Charybdis, he escaped the twin hazards at the cost of only six of his sailors’ lives.

 No such luck for Crowe Horwath (HK) CPA Limited, the Hong Kong member firm of the eighth largest of the global accounting networks, and auditor of 22 modest-sized companies based in China and filing financial statements in the US with the Securities and Exchange Commission.

By its order dated July 27, 2017, the Public Company Accounting Oversight Board censured the firm and revoked its registration, for its refusal to produce documents to the PCAOB to enable its “access to the information that is necessary to be able to inspect (Crowe’s) audit work as required by the (Sarbanes-Oxley) Act and PCAOB rules” (¶ 2).

The audit firm defended its position based on a direction from the Chinese Ministry of Finance under that country’s laws. Sympathy is in order for Crowe Horwath’s global CEO, who Tweeted (@jkevingmcgrath), “Our Hong Kong member firm (is) caught between compliance with laws & regulations of the Chinese govt and their desire to comply with the PCAOB.”

Thus is brought forward a hostage to fortune that was embedded in the prospect of cross-border clashes of sovereign powers, immediately with the post-Enron enactment of Sarbanes-Oxley in July 2002 -- legislation that created the PCAOB and its inspection and oversight authority over the auditors of US-registered public companies.

That is, the PCAOB has been failing since 2002 to fulfill its members’ wishful promises of solutions to its inability to conduct inspections of Chinese firms – history dating to the PCAOB’s willingness to register non-US audit firms despite their explicit declarations of foreign legal impediments to compliance with its inspection regime.

The PCAOB’s revocation order made clear (¶ 10) that Crowe Horwath was to get no regulatory surcease under the May 2013 Memorandum of Understanding with the Chinese Securities Regulatory Commission and the country’s Ministry of Finance – deprecating that document (¶ 11) as a “non-binding agreement between the signing parties.” So stated, the PCAOB effectively conceded the internal inconsistency between the MOU’s “intent with regard to mutual assistance and the exchange of information for the purpose of enforcing and securing compliance with the respective Laws and Regulations of (the parties’) jurisdictions” and the bail-out that “it is ‘not intended to create legally binding obligations or…supersede domestic laws’ of the parties” (ellipsis in the order).  

The PCAOB’s slap at Crowe Horwath might demonstrate effective agency muscle – or, as likely, could be foundational for dramatically unintended consequences. While the firm’s China-based US registrants will be forced to look elsewhere for audit services, there are broader reasons to be skeptical.

To start, Paul Gillis in his China Accounting Blog for July 26 calls out the agency to “pick on someone their own size” – with implications much deeper than a dig at the Big Four’s dominance of the large-company market in China.

Here is the context: at last count there were reportedly 92 Chinese companies with securities listed on the American exchanges. The upper end is totally dominated by the Big Four – of the ten largest companies in Standard & Poor’s index of the top 50 US-listed Chinese firms, PwC’s member firms audit six – Deloitte three – EY one.

Meanwhile, questions about accounting and reporting in China are fraught and persistent – the year-ago news of an SEC investigation into the accounting of Chinese giant Alibaba makes the point. An eruption of financial malfeasance in China is a simple inevitability, on a scale to have disruptive effect on the share prices of companies listed in America, to which the American regulators will be obliged to fashion a responsive strategy.

Those reactions will be intractably complicated. The SEC will be unable to secure documents and testimony, on the assumption that the Chinese securities regulator would exercise the veto granted in the largely illusory “settlement” of February 2015 – and the PCAOB will be prolonged in the paralysis of its fifteen-year inability to inspect.

Yet with its enforcement action taken against Crowe Horwath’s Hong Kong firm, the PCAOB has firmly nailed its policy colors to the mast – and (to thoroughly mix the metaphors of maritime hazard) will now, with its blind eye turned to the future, cruise merrily along until it too strikes the rocks.

That is because, to maintain any semblance of credibility as enforcer, it would seem obliged to maintain consistency with its sanction of Crowe Horwath, up the ladder of size to events involving Big Four clients. Yet – yanking the ticket of a Big Four firm in Hong Kong or China would have repercussions going to the heart of the global Big Audit model. Simply put, a regulatory deathblow against a Big Four firm in an economy the size of China would threaten the integrity and presage the collapse of a global Big Four network. And in turn, the limited range of auditor replacement choice renders impossible the functioning of a “Big Three” model – whether for the US-listed sector of large Chinese companies on its own or on the larger global stage.

Or put in Homeric terms – by pursuing Crowe Horwath between a rock and a hard place, the PCAOB may very well have sailed itself into those same troubled waters.

 

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

 

And please also consider the comprehensive discussion of these issues in the new edition of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – just released by Emerald Books and available at Amazon.

If The Big Four Went “Ex-Advisory” – Déjà Vu? Or Worse?

Will this be the year that history repeats -- when the Advisory practice of one or more of the Big Four breaks away from Audit? What would a reprise look life, of the withdrawal from consulting they made between 1998 and 2001?

The inquiry is of interest, to the firms' partners, employees and clients -- and not least to all users of the audited financial statements of the world’s large public companies.

The conditions are all present, and ominous, for two reasons.

First, taking the various regulators at their word, they have a distinct distaste for the growth of Big Four “Advisory” -- as consulting is now cosmetically re-labeled. In a Washington speech on December 9, 2013, PCAOB chairman James Doty observed that:

“We have, in recent weeks, seen publicly reported examples of a resurgence of audit firms into consulting to bolster revenue. Of what consequence are these developments for the audit function? What are the implications for independence of the audit function? ... What are the risks of other business lines and how do they affect resource allocation and investment in audit?”

In the same vein, PCAOB member Lewis Ferguson, in his then-capacity as chair of the International Federation of Independent Audit Regulators, was quoted at an IFIAR press conference on April 10, 2014, that the auditors’ search to acquire expertise in Big Data and its applicability to auditing “is a source of great concern to all regulators around the world,” and “raises serious concerns about differential levels of profitability in these businesses, differential rates of growth, where the economic incentives are and to what extent does audit quality suffer as a result” (emphasis added).

Second, the bureaucrats’ antagonism aside, there are sustainability implications in the continued growth rate disparities between practices. Audit revenue growth for the Big Four is stagnant in the low single digits, while their Advisory practices continue the trend of recent years, positive in the mid-teens.

As a model for the evolution of the practice mix of the large firms, Deloitte’s 2016 Advisory revenue, according to its global annual report, was absolutely $ 3.5 billion larger than Audit; its Assurance and Tax together only measured above 50% of its global total by including Risk Advisory on that revenue line.

Memories long enough will recall the large firms’ various exits from their consulting businesses, with their unfortunate capitulation to the regulatory and political pressures on permissible scope of ancillary services to audit clients:

• EY’s sale to CapGemini in February 2000.

• KPMG’s 2001 spin-off to create what became BearingPoint.

• PriceWaterhouse’s sale of its practice to IBM in July 2002.

• Most especially, the bitter and avoidable divorce between Arthur Andersen and Andersen Consulting, commenced in 1998 and finalized with the launch of Accenture on January 1, 2001.

Despite Andersen’s cohesion, profitability and market position – never matched even in the dreams of its peers -- its leaders were unable to overcome their structural stresses or resolve the issues of client service constraints, disparate profitability and allocations of authority and governance influence.

With the internal, regulatory and litigation pressures all mounting today, it is both too easy, and thoroughly dispiriting, to imagine a repeat – one that for all the public may know is percolating even as we speculate.

It is, to say, not difficult to picture a quorum of unhappy non-Audit partners, delivering ultimata to their leaders that demand structural revisions to compensation packages and promotion incentives and organizing documents. Meanwhile, other dissidents would be lawyering up and engaging teams of bankers to model the costs and opportunities of a practice line break-up or break-down.

Since the plausibility and possibility cannot be ignored, what would the model for Big Audit look like, if delivery were soon to be done by four firms comprising audit and tax practices alone?

First of all, Big Four rankings on a 2016 “audit and tax” basis would be (in US $ billions): PwC - $ 24.4; Deloitte - $ 20.4; EY - $ 19.05; KPMG - $ 15.7. The revenues of their US practices would array between $ 6.6 and $ 9 billion.

One element at the heart of the concerns is that of fragility and survivability. For this, the analysis is pertinent that I have done here in the past – calculations of the financial “tipping points” – that is, the size of a “worst case” litigation or law enforcement outcome that would destabilize and disintegrate a Big Four network.

No fun – although necessary in any grown-up discussion of what such a model for Big Audit might look like – that analysis yields indicated break-up numbers well below $ 1 billion. That is hardly enough to register, in an environment where VW has agreed to pay out some $ 22.5 billion to resolve only the US portion of its penalties for its diesel emissions “defeat” software; with Rolls-Royce’s penalties for twenty years of global bribery to include £ 671 million in fines to authorities in the UK, the US and Brazil; and where disclosure of the cost of irregularities in the Italian business of BT Group knocked the company’s value by over £ 6 billion in a single day.

These are figures disturbing enough to give serious pause. But even as the atmosphere of denial on this subject prevails, there are also disturbing implications for the ability of these reduced organizations to serve the assurance needs of the world’s capital markets. That is, as the case for the traditional “pass/fail” auditor’s report continues to erode, the prospect of reviving its value by “shrinking to success” would look increasingly dubious.

Here the concern is about the ability to evolve, when the personnel who would leave with the departing Advisory practices would strand the auditors without the support of such diverse talents as the data analysts and software designers, engineers and robotics experts, economists and lawyers and bankers alike – expertise lured away in a repeat of history by the enticements of unfettered stand-alone Advisory opportunities.

Both regulatory hostility and diminished professional capabilities would challenge the ability of an “audit only” Big Four to respond to the implications of the inevitable. The genie of change is already recognized as out of the bottle, and will not be returned. If the audit firms handicap themselves with a failure to stabilize, evolve and maintain truly full-service structures, business models and methodologies accordingly, then new players to serve the market’s demands surely and shortly will appear.

So – is another Audit/Advisory split on the horizon, with all the unpleasant consequences? No prediction is made here – but under today’s conditions, no bet against it either.

 

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A Fresh Year, Fresh Problems, And A Fresh Look at the Big Four’s “Tipping Points”

Financial malfeasance has started this New Year with a bang.

Two bangs, actually: on January 17, Rolls-Royce admitted to a twenty-year history of corporate bribery on a global scale, for which the first level of its penalties includes guilty pleas, deferred prosecution of multiple felony charges, and fines of £ 671 million to authorities in the UK, the US and Brazil; and on January 24, the trebling to £ 530 million of the previously announced cost of irregularities in a business at BT Group’s Global Services in Italy that last year had less than £ 100 million in earnings -- knocked 19% or £ 6 billion off BT’s shares in a single day.  

Shareholder plaintiffs are off to the courthouses, and once again the cry is heard, “Where were the auditors?”

While litigation results and answers will emerge in due course, new problems this big call for the re-visit of an old topic. Starting back in 2006, and in updates since, I have compared the “worst case” litigation risks faced by the Big Four accounting firms with their capacity to withstand a shock on the scale of Enron’s fatal impact on Arthur Andersen in 2002.

The inquiry is neither pleasant, nor the insights attractive. But there are two reasons for the attention:

First, Big Four growth has driven their combined global revenue near $ 128 billion for fiscal 2016. But nothing since Andersen fell makes the capital-thin balance sheets of the surviving tetrapoly any more robust against an outcome of similar “black swan” magnitude.  

Second, intense criticism continues, over the roles and performance of the international networks that provide audit services to virtually the entire population of the world’s large public companies. A sampling, just in the last year:

• The SEC and other global regulators are up in arms over the widespread practices of public companies to report financial results in their own favor, using “non-GAAP measures” – that is, techniques other than Generally Accepted Accounting Principles.

• The SEC landed on EY in September for two different independence violations, based on inappropriate relationships between audit partners and client financial executives.

• In December the PCAOB blistered Deloitte, for admitted alteration of documents and false testimony by its personnel in Brazil, along with separate lesser proceedings in Mexico and the Netherlands.

• And the events at Rolls-Royce and BT Group only refresh the list of adverse corporate behaviors recently including Valeant, Wells Fargo and Toshiba.

To re-cap – in September 2006 the consulting firm London Economics reported to the EU markets commissioner, using a model that tested the threat to the viability of a large UK accounting firm – based on the finite tolerance of individual partners for personal financial sacrifice, before a critical number would withdraw their capital and throw a firm into a death spiral.

Assumptions and scenarios in the model included the impact of a crisis environment on reputation, revenue and profitability, and hypothetical take-home reductions for the partners of from fifteen to twenty percent and extending over three to four years.

Extrapolating the UK model out on a global basis and up-dating for current numbers, the Big Four “tipping points” can be calculated – today suggesting the risk of potential disintegration at between four and six billion dollars.

Calculations at the global level are only first steps, however. That is because as in 2002 with Andersen – whose profitability and global cohesion exceeded any of its peers, yet fell apart in a matter of weeks – the destabilizing forces of a multi-billion dollar imposition surpass the ability of these networks of individual partnerships to maintain their global integrity and mutuality of support.

Instead, the threat was on plain display in August 2016, when PwC’s US firm confronted damage claims of $ 5.5 billion dollars, brought in Florida by the bankruptcy trustee of the mortgage underwriter Taylor Bean & Whitaker, relating to the firm’s audits of Colonial Bank, the sixth largest American bank failure coming out of the financial crisis of 2007-2008.

Unable to resolve the lawsuit in advance of trial, PwC endured three weeks of courtroom hostilities before reaching a settlement. The amount was undisclosed and still confidential – within the firm’s capacity but surely large enough to be painful both fiscally and organizationally.

With exposures in the US both the largest and the most likely, among the world’s large economies, single-country calculations are needed – where under the London model, break-up numbers for the America-only firms shrink from about three billion down to a truly frightening figure below one billion dollars.

Relevant factors[1] include:

• The context of the last decade in which litigation outcomes have escalated far beyond the firms’ ability to respond.

• The reasons why and how the business models of the Big Four, contrasted with the banks and other big-dollar defendants, can operate with levels of capital so limited that their viability can be threatened at such derisory levels.

• The irrelevance of the role of insurance at the levels of existential threat, either in the commercial marketplace or within the Big Four structures themselves.

The punch line is the same as when first raised a decade ago – a critical lesson from the collapse of Andersen that has not been learned:

The loss of another Big Four firm would throw the entire Big Audit model into chaos, for want of replacement choices and the unwillingness of the three survivors to stay in an unbearably risky business.

Instead, the Big Four are down to their critical minimum. The present four-firm structure is irreducible, given the uneven concentrations of their personnel, market share and industry expertise around the world, and the politically imposed restrictions on auditor choice due to outmoded concepts of independence.

If one more goes down, they all go down. So the stability of the entire wobbly structure rests on the continuing survival of them all, including the weakest.

And on that lesson is where real concern should rest.

Coming up: What would be the impact if the regulators got their wish – if the Big Four split off their Advisory and Audit practices? “Déjà vu” all over again?

 

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[1] Readers are invited to more detailed treatment in my earlier posts of January 6, 2015, and November 30, 2011, and my book on the fragility of the large-firm audit model -- “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” published by Emerald Books in December 2015.

Guest Op-Ed: Should FSOC Designate the Big Four As “Systemically Important”? How Not – And Yet Then What?

The question above, about the definition and scope of large bank regulation, may seem a bit wonk-ish. Unless you happen to be a large bank officer or director -- or a bank regulator – or maybe a bank client -- or a bank’s auditor or other gate-keeper.

Welcoming all readers to a new year that promises to be full of challenges, this topic kicks off 2017.

I am pleased to pose the question as co-author with Bill Kring, senior academic researcher at Boston University’s Center for Finance, Law & Policy, at today’s blog BankThink, published by The American Banker and dealing with ideas, trends and other developments in financial services:

“Efforts to mitigate the impact of systemically important nonbanks on the global economy have largely omitted a sector deeply entangled with financial institutions across the capital markets: the big accounting firms.

“The Financial Stability Oversight Council (is) mandated by the Dodd-Frank Act to designate ‘systemically important financial institutions’ for bank-like regulation….

“While FSOC’s future authority is somewhat in doubt as President-elect Trump sets to take office and the GOP has maintained control of both chambers of Congress, the work of regulators to contain systemic risks is no less important. And they should turn their attention to the ‘Big Four’ auditors that, despite being nothing like a bank or a broker-dealer, provide the audit opinions legally-mandated for all of the SIFI-designated institutions (emphasis added).

(For the entire piece, please see BankThink for January 9, 2017.)

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“Rise of the Robots” – Part Three -- Cognitive Technology Threatens Us All

A reader’s skeptical comment on the second of this series -- here Part I and Part II -- on the ominous messages for the accounting profession in Martin Ford’s prize-winning book of last year, Rise of the Robots, was that, "The elephant in the room (is) that automation is nowhere close to being able to make complex judgments which are routine in the type of audit and accounting jobs that are relevant to the people who read GC,” asking if, by analogy, I was “seriously trying to argue that an attorney, currently working at a firm, needs to worry about their job prospects due to automation?"

Rather than shooting at the messenger, a deeper look at Ford’s discussion may be in order. Although that may likely only increase the level of unease and upset.    

To round out the picture of the speed with which high-functioning drones and robots will displace the jobs and careers of the humans in traditional audit, Ford focuses on the ever-expanding pace with which Big Data analytics, artificial intelligence and cognitive technology can be expected to displace the higher-order roles of human expertise and professional judgment.

His proposition, in summary, is that any professional’s position is at risk, who sits at a desk and interacts with either words or numbers, or teams up with software that is self-learning and therefore likely to dispense promptly with its human collaborator.

As Ford himself puts it:

        "If you find yourself working with, or under the direction of, a smart software program, it’s probably a pretty good bet that –- whether you’re aware of it or not –- you are also training the software to ultimately replace you."

For the rest of the piece, please continue at Going Concern for August 24.

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Le Monde and I discuss: "Quand les « Big Four » s’écrouleront"

 

While in London last month to promote my recently-published book on the fragile and threatened state of the Big Audit model, under which the four big international accounting networks provide audit services to the world's largest public companies, I had the pleasure of an extended discussion with Eric Albert, correspondent for the prominent French newspaper Le Monde, whose "Lettre de la City" appeared in the paper's edition for April 6 (below and here). Albert's lead requires translation, not only for vanity's sake, and his concluding paragraph captures the essential message of "Count Down":

"Quand les « Big Four » s’écrouleront"

Jim Peterson n’a pas franchement l’apparence d’un révolutionnaire. Nœud papillon, costume impeccable sur des souliers cirés, cheveux blancs tirés en arrière, l’Américain incarne parfaitement ce qu’il a longtemps été : un avocat d’affaires de haut vol, qui a très bien gagné sa vie en défendant les grands cabinets d’audit.

("Frankly, Jim Peterson does not have the appearance of a revolutionary. Bow tie, impeccable suit and shined shoes, white hair combed straight back, this American perfectly incarnates what he has always been: a high level business lawyer who has made a great life by defending the big audit firms.")

Derrière ses allures policées, son message est pourtant explosif.

Lui qui a longtemps été un homme du système, qui a connu de l’intérieur tous les rouages de la comptabilité des grandes multinationales, tire la sonnette d’alarme : les « Big Four », ces quatre grands cabinets d’audit internationaux (PwC, Deloitte, KPMG, Ernst & Young) risquent de s’effondrer à tout moment. « Ils sont plus fragiles qu’Arthur Andersen en 2002 », nous expliquait-il lors d’un récent passage à Londres, faisant référence à la faillite retentissante de l’ancien cabinet d’audit.

Urgence

Selon lui, l’urgence est réelle : « On ne peut pas survivre avec seulement trois auditeurs. Tout le système financier mondial se bloquerait si on arrivait à ça. » Pour tenter d’alerter l’opinion, il a récemment publié un livre ardu mais important sur le sujet (Count Down : The Past, Present and Uncertain Future of the Big Four Accounting Firms, Emerald Group Publishing, 2015).

Dans une première vie, Jim Peterson a longtemps enchaîné les emplois dans les grands cabinets d’audit. Son travail : les défendre à chaque fois que ceux-ci étaient attaqués en justice . Son dernier poste : avocat chez Arthur Andersen, justement. Sa chance a été d’atteindre l’âge de la retraite
en 2001, juste avant le scandale Enron.

Quelques mois plus tard, le géant américain de l’énergie s’écroulait, une vaste fraude comptable étant mise au jour. L’auditeur ? Arthur Andersen, qui s’était montré complice actif. Risquant les poursuites judiciaires, le cabinet a lui aussi fait faillite. « Il s’est écroulé en moins de deux semaines, rappelle Jim Peterson. Les associés situés à l’étranger ont été les premiers à partir , et tout le système a chuté derrière. »

Les scandales se succèdent

Cette faillite, qui a fait passer le monde du « Big Five » au « Big Four », a mis en évidence l’extrême fragilité financière des grands cabinets d’audit. Cela peut paraître paradoxal. En apparence, Deloitte, KPMG, PwC et Ernst & Young sont d’énormes réseaux internationaux, qui dominent le monde . Pratiquement aucune grande entreprise n’échappe à leurs tentacules : les quatre grands sont les seuls à savoir auditer des multinationales présentes dans des dizaines de pays, jonglant entre les paradis fiscaux et les lois du commerce international .

Pourtant, ils n’ont pratiquement aucune réserve financière. Ce sont des réseaux, sans holding centrale, qui appartiennent aux associés. Ironie du sort, les Big Four sont particulièrement peu transparents sur leurs propres comptes et il est très difficile de connaître leur état financier. Mais selon les calculs de Jim Peterson, il suffirait d’une soudaine perte de 1 milliard à 6 milliards de dollars, suivant les cas, pour provoquer une faillite : le genre de somme parfaitement réaliste par rapport aux énormes amendes ou aux poursuites judiciaires que subissent les banques depuis quelques années.

Or, les scandales comptables se succèdent avec la régularité d’un métronome. Les supermarchés Tesco ont révélé en 2014 avoir surestimé de plus de 300 millions d’euros leurs profits. Au Brésil , le scandale Petrobas pourrait bien avoir de sérieuses conséquences pour son auditeur, PwC (la Fondation Bill et Melinda Gates, actionnaire de Petrobas, le poursuit actuellement en justice). Et Deloitte a aussi eu très chaud en 2013, quand il a été poursuivi pour 7 milliards de dollars pour ne pas avoir vu venir la faillite de Taylor Bean, l’un des plus gros prêteurs immobiliers américains : un accord à l’amiable a finalement été passé.

Éviter la connivence

Mais après tout, pourquoi craindre une faillite de l’un des Big Four ? Contrairement aux grandes banques, leur survie n’est pas essentielle à la bonne conduite du système financier mondial. Faux, réplique Jim Peterson. Il rappelle que de plus en plus de pays obligent les entreprises à changer régulièrement d’auditeur, pour éviter la connivence.

Dans le même temps, les cabinets n’ont pas le droit de fournir des conseils aux entreprises qu’ils auditent, toujours pour la même raison. Résultat, avec seulement quatre grands cabinets, le choix est déjà extrêmement limité. « Récemment, une grande multinationale avait l’obligation de changer d’auditeur, pour respecter la loi. Elle avait donc le choix entre les trois concurrents : mais deux d’entre eux ont dû se retirer parce qu’ils lui fournissaient déjà des conseils », raconte Jim Peterson. Il n’en restait plus qu’un. « Si on arrive aux Big Three, beaucoup d’entreprises n’arriveront plus à trouver d’auditeur, alors que la loi les oblige en a avoir un. On risque de se trouver dans une situation complètement bloquée. »

Pour l’instant, à son grand désespoir, le sujet ne semble ne pas intéresser grand monde. Mais quand une crise éclatera, et que le système financier sera confronté au problème, le monde aura comme d’habitude réagi trop tard.

("At the moment, much to his chagrin, the subject does not seem of interest to many people. But when a crisis breaks out, and the financial system ends up facing this problem, the world will -- as usual -- have reacted too late.")

 

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In Print: “A Look at the Profession’s Uncertain Future” – The CPA Journal

Through 2015 The CPA Journal – published by the New York State Society of CPAs – observed its 85-year history with comprehensive exploration of the profession – past, present and future.

It was my pleasure to offer a guest editorial in the Journal’s issue for December – copied here[1] -- “A Look at the Profession’s Uncertain Future: A Rough Path Lies Ahead for ‘Big Audit’.”

The views briefly reprise the themes in my book, also released last month – “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” – which explores the interrelated forces that challenge the sustainability of “Big Audit” -- the current fragile model by which assurance is delivered on the financial statements of the world’s large public companies.

Access to the Journal is either by membership in the New York society or by subscription. For the valuable insights available from this important “voice of the profession,” one choice or the other is recommended.

 

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[1] With the generous permission of The CPA Journal, Voice of the Profession, December. 2015, all rights reserved, and thanks and appreciation to Rich Kravitz, its editor-in-chief.

“Count Down” Is Published

It’s out. Emerald Publishing has this week released my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”

With my hearty thanks to those who voted their confidence by ordering early, and who should be expecting delivery – Amazon promptly reported itself to be “temporarily out of stock.” Based on that under-estimate, optimism seems in order, that this story -- the fragility of the Big Audit model -- will appeal across the broad audience for whom it is intended.

To my valued readers – if you find the themes engaging, please share with your friends and colleagues -- and a kind word or two by way of review on Amazon would be appreciated as well. If the topics are somewhat disturbing – I will take that for success, as the threats to the status quo and the complex future of Big Audit present daunting difficulties. And on the other hand, if you may feel I have got it all wrong, write to me directly – [email protected]; in due course I will be taking all reactions into the work on the paperback edition that is to come.

And by the way, receipt of your feedback will be noted and allow me to relieve your inbox by shortening the list for future mailings.

 

 

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Guest Post: “Count Down” Speaks to Several Audiences

Thanksgiving will have extra meaning this year – it’s the week set for Emerald Publishing’s release of my book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”

It's the home stretch – the type-setters have my last handful of changes, the proofs of the index are turning around, and advance copies will ready to go out in the up-coming days.

Among the several audiences for “Count Down” are the young professionals and accounting students. Wherever located around the profession, their job choices, work environments and future career directions are and will be acutely affected by conditions in the market for "Big Audit" -- the structure and business model, with all its tensions and fragilities, by which audits are performed for the world's large public companies -- almost entirely by the Big Four.

On which, I had the pleasure last week of writing for Going Concern, edited by Caleb Newquist and aimed at this enormous, vocal and energetic cohort. Here is its opening:

Learning From Andersen: Opportunities and Pitfalls in a Long-Term Audit Career With the Big Four

Does anyone remember –- or care about -– the collapse of Arthur Andersen back in 2002? If recalled, what lessons might it have for young professionals taking serious stock of their career choices?

Andersen had been by far the most profitable, tightly organized and centrally governed of the large accounting firms that once were the Big Eight. It was nobody’s candidate for rapid, scandal-driven disintegration.

When Andersen crashed, the partners lost their capital, and all their post-retirement benefits. More importantly, all the Andersen employees lost their jobs. Careers had to be re-built out of the wreckage.

And today? Nothing has happened since 2002 to give anyone confidence that the surviving Big Four could withstand the shock that destroyed Andersen and upset the lives of everyone it touched.

Who should care, and why?….  Going Concern readers all have skin in this game.

For the rest of the post in its entirety, see Going Concern for October 29.    

“Count Down” is available for order now, directly through the Emerald Bookstore or from Amazon.

 

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“Count Down” – Now It’s A Matter of Proof

A stack of 240 freshly typeset pages sits on my desk. This week is fully committed to red-pencil proof-reading, for Emerald Publishing’s intended early-November release of “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms”.

The task provides something to prove, in a second sense -- the first being the book itself: my take on the fundamentally threatened state of the current Big Audit model, and the broad scope of the re-engineering required to evolve a sustainable structure for privately-delivered assurance on the financial information issued by the world’s large companies.

There is resonance in reaching this final stage of a book on Big Audit. The first modern independent auditor’s report – William Welch Deloitte's on the half-yearly accounts of the Great Western Railway as of December 31, 1849 – stated, in its entirety, “Audited and approved” (my emphasis). 

From the Latin, probare, to test or to probe – the root for the English, both nouns and verbs.

Across a full range of human endeavor – proofing and proving extend from the editor’s desk to the geometrician’s theorems to the scientist’s hypotheses to the chef’s puddings. Not to offer a guaranty, or a zero-defects promise, but to test or evaluate or assess, in the quest to advance the quality of information, communication and knowledge. 

So it has been for modern auditors, over the span of 165 years -- sampling and testing and evaluating.

In none of these contexts is the process so hubristic as to presume or conclude perfection – a state of grace beyond the performance limits of auditors and proofreaders and the others alike.

Best efforts devoted, flaws will still lurk undetected in these 80,000 words. And I will not be pleased when, post-publication, they pop out into the open. But it will not be for lack of trying.

“Count Down” is now available for pre-publication ordering, direct from the Emerald Bookstore or through Amazon -- as I would be most pleased to have readers here prove for themselves.

 

 

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Book Announcement: "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms"

For those who may have wondered -- my reduced schedule here in recent months had a reason: completion and readying for publication of my book, "Count Down -- The Past, Present and Uncertain Future of the Big Four Accounting Firms".

I am pleased and proud that the book is next in the Emerald Publishing Group's series, "Studies in the Development of Accounting Thought," edited by Gary Previts, E. Mandell de Windt Professor of Accountancy at Case Western Reserve University, member of the Accounting Hall of Fame and past president of the American Accounting Association.

Its scope -- bringing together themes long explored here and going back to my column in the International Herald Tribune -- is summarized in this from Emerald:

The post-Enron disintegration of Arthur Andersen in 2002 reduced to the surviving Big Four the number of international accounting firms that audit nearly all of the world’s largest public companies -- Deloitte, EY, KPMG and PwC.

 Despite their strengths -- market dominance, double-digit annual growth in non-audit services and continued revenue expansion to a global total above $ 120 billion in 2014 – the viability of the Big Four and their business model faces serious threats:

• Widespread dissatisfaction with the standard form and language of their core product -- the traditional “pass-fail” auditor’s report.

• The persistent “expectations gap” between their perceived performance quality and the stated desires of information users.

• Difficult relations with regulators and oversight agencies.

• And especially, the questionable ability of the Big Four and their partners to survive a “black swan” financial shock – a litigation judgment or law enforcement sanction on the scale that destroyed Arthur Andersen.

"Count Down" looks at the complex challenges facing the Big Four, questions the feasibility and achievability of the various proffered “solutions,” and proposes an evolved model for Big Audit that would be both sustainable for the large firms and fit to serve the capital markets of the 21^st century.

“ This book lifts the lid on the story behind the financial statements of the world’s major companies. If you want to understand the system that is allegedly validating the reported data - and why the system is a clone of the Maginot Line - expensive, obsolete and irrelevant - read on. Weak as the present system is, there is a solution. It will take a major change in regulatory attitude and a fresh approach, unfettered by history. The section on the imaginative use of Big Data is worth study by itself. “

     -- Duane R. Kullberg, Arthur Andersen & Co., S.C. Chief Executive Officer, 1980-1989

“Illusions of safety in size doomed allosaurus, empires, and auto makers. In his Count Down, Jim Peterson examines the fragility of the ineffectual audit regime, and the imminent threats to its survival. Peterson combines the insider’s knowledge with an outsider’s critical but sympathetic perspective and suggestions in this fascinating and insightful volume—a must-read for accountants and students of accounting.”

     -- Shyam Sunder, James L. Frank Professor of Accounting, Economics, and Finance, Yale School of Management

Scheduled release date is October 15. For information, and to order:

     From Emerald Books

     From Amazon

Please share with your friends and colleagues. For questions and other inquiries -- and for Emerald's pre-publication discount -- please write me: [email protected]

The Financial Fragility of the Big Four Accounting Firms – Updating the “Tipping Point”

            “Predictions are difficult. Especially about the future.”

-- Variously attributed to an old Danish proverb, physicist Niels Bohr, and Yogi Berra

It’s a new year. The holidays are over. Time to sober up, get back to work, and re-fresh this sobering question:  

How big is the “worst-case” litigation hit that would disintegrate one of the surviving Big Four?

Since the post-Enron collapse of Arthur Andersen, it has been too easy to ignore this gloomy topic in a combination of indifference, unease and denial. But the answer matters. Financial information users should care, because the loss of the next firm would bring on the collapse of the entire structure of Big Audit – the system of privately-provided assurance on the financial statements of the world’s large companies.

I did this first in December 2006, with periodic updates, even as the Big Four have shown continued growth – total global revenues for Deloitte, EY, KPMG and PwC for fiscal 2014 are up above $ 120 billion.

Back in September 2006, a report by the consulting firm London Economics to the EU markets commissioner modeled the collapse of a Big Four partnership in the UK.

As had actually happened at Andersen in 2002, the model quantified the level of personal sacrifice, beyond which the owner-partners would lose confidence, withdraw their loyalty and their capital, and vote with their feet.

The London report observed that the firms’ viability would be hostage to the combined effects of a highly-charged crisis environment, reputational pressure and the hostile publicity of a massive adverse litigation result. Using a variety of scenarios and assumptions, it concluded that critical numbers of partners would defect, so as to put a firm into a death spiral, if they faced a profit reduction of from fifteen to twenty percent that extended over three or four years.

Bearing on the model, but poorly appreciated if at all, is that the Big Four networks operate on razor-thin levels of financing, for three reasons:

• Their financial needs – employee salaries, space costs and technology and methodology investments – are covered out of client-derived revenues.
• Income taxes in the largest countries are cash-based for partners -- a powerful incentive for the firns to distribute out their current income.
• And with no alternative need for excess capital or outside investment, idle cash would serve only to whet the appetites of the litigation sharks circling in the feeding tanks.

By extending the London Economics assumptions to the global level and coming down to date, break-up figures for the Big Four can be calculated -- from an optimistic maximum of about seven billion dollars down to about three billion.

But this is only the first step. Those are world-wide numbers, which assume that a Big Four network under deadly threat could maintain its global integrity and the on-going support of its firms and partners around the world.

The contrary was unfortunately illustrated by the flight of Andersen’s non-US firms in 2002. Cohesion of the international networks under the strain of death-threat litigation, or the extended availability of collegial cross-border financial support, cannot be assumed.

So calculations must be made on the Americas alone -- the US being still the world’s most hazardous litigation venue. Left to their own resources, as was Andersen’s US firm, the tipping points for the US practices shrink to a range from $ 3.6 billion down to a truly frightening $ 900 million.

Ominous and shockingly small as are these litigation-driven figures, they have never been disputed. A public discussion would be illuminating, but financial fragility is a “third rail” topic for the profession’s leadership. No alternative models or other estimates have ever been offered. Nor is there anywhere in sight any credible claim that a political or regulatory solution is achievable.

Is there a persuasive case that it won’t happen – especially in the face of the empirical evidence of Andersen’s collapse, that it truly can? The answer, with regret, is negative.

In the aftermath of the financial crisis of 2007-2008, the large accounting firms disposed of huge litigations for remarkably modest sums – examples include KPMG resolving Countrywide and New Century, Deloitte settling Washington Mutual, and EY settling the private investor portion of its exposure in Lehman Brothers.

But multi-billion dollar figures have become all too common and familiar, e.g., to settle claims relating to the financial crisis, the sales of mortgage securities, and LIBOR and Forex rate-fixing. Bank settlements reported for 2014 alone have totaled over $ 56 billion -- led by Bank of America’s agreement in August to a sub-prime-mortgage settlement of $ 16.9 billion, and the $ 8.9 billion fine finally agreed by BNP Paribas the following month, after the tone-deaf intervention tactics of the French government officials.

Outside the financial sector, perhaps heading the list of complex mega-settlements is the total for BP arising out of the Deepwater Horizon oil well catastrophe -- $ 4.5 billion in fines and penalties, and $ 13 billion (and growing) for claimed loss by businesses, individuals and local governments.

Those settlements and government fines could only be funded, however, out of the investor-supported balance sheets of the publicly-held banks and other corporate defendants. By contrast, third-party equity is simply not available to the private accounting firms owned by their individual partners.

Given the continued myth that the Big Four are protected by insurance, it must also be noted that these numbers are net of whatever cover may in fact be available. Which is neither good news nor especially relevant.

That is because of the effective absence of commercial insurance coverage of the large firms at the currently expanded catastrophic levels. The fickle cyclicality of the insurance market means that even today’s shrunken, thin and ragged insurance capacity would ill protect against the chilly horrors of the inevitably recurring new litigation nightmares.

To recap, these numbers matter because loss of another Big Four firm would throw the entire system into chaos – for lack of auditor choice and readiness among the survivors to stay in an unbearably risky business.

Accounting and assurance have been essential to commerce going back to the earliest records of societies engaged in trade. But the partners of the large firms are not indentured, nor on-call hostages to the unexamined assumptions of the world’s politicians and regulators.

Yet the reactions of regulators, politicians and the general public to any serious adjustment to the potentially fatal Big Audit liability regime range from lukewarm to downright hostile.

It cannot be assumed – just because the surviving Big Four were able to absorb the clients fleeing Andersen in 2002 – that a Four-to-Three scenario is viable today.

To the contrary, the Big Four are already down to a critical minimum. The uneven concentrations of personnel, market share and industry expertise around the world, the politically-imposed restrictions on auditor choice due to outmoded concepts of independence, and the post-Andersen fragility of the large firms’ networks, combine to show that a four-firm structure is irreducible.

As the catastrophic impact of rare but devastating “black swan” events makes clear, it only takes a single one.

 

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Around the Media – “The Economist” Gets A Good Deal Right

Recognition should be given where deserved. Mainstream media reporting on the grave challenges to the viability of the Big Audit model is typically so uneven and ill-informed that generosity favors freely extended tips of the hat.

Perhaps especially to express appreciation for the pick-up of a few choice words of my own.

So please do read the piece in the current issue of the Economist – “Accounting scandals - The dozy watchdogs”.

I had spoken at length with its author, Dan Rosenheck – with whom I am in considerable alignment, especially on our shared view that the historical “pass-fail” auditors’ opinion is sadly deficient to provide value to the complexity of today’s demanding capital markets.

Rosenheck quotes me thus:

“An auditor’s opinion really says, ‘This financial information is more or less OK, in general, so far as we can tell, most of the time’, says Jim Peterson, a former lawyer for Arthur Andersen, the now-defunct accounting firm that audited Enron. 'Nobody has paid any attention or put real value on it for about 30 years.'"

Where next? With the “expectations gap” so glaringly wide, and the perception of inadequate auditor performance so widely expressed, where does the dialog need to go?

Regular readers here will know my attention to the unachievable nature of the “magic bullet” solutions put forward by those who combine their passion for the subject with their ignorance of how Big Audit actually operates – for examples of which, see the reader comments reacting to the Economist piece as representative.

In this, I admit lack of success in calling off Rosenheck from two glaring examples:

• Selection or actual performance of audits by agencies of government – suggested by the New York Times but which I have discussed (August 20, 2014) as being so impractical as to attract and deserve nothing but howls of derision.

• And the fantasy of “audit insurance” – a long-discredited notion from academia that not only fails both the basic principles of insurability and the capacity of the market to provide coverage for the multi-billion dollar failures that threaten the lives of the Big Four accounting firms, but which is conclusively shown to be impractical by the simple fact that if realistic, it would already have been put in place by the insurance industry itself (see my posts going back to May 5, 2008, and July 15, 2008).    

Which does not take away from this central point:

If the dialog on the survivability of Big Audit is not treated as important and worthy of candid engagement by all the interested players, then its very viability is threatened by the kind of “Black Swan” event that would require re-design of large-company audit out of the wreckage after a catastrophic collapse.

And that threat should be appreciated as far too disruptive to be tolerable. 

 

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Deloitte's Audit Ban in Saudi Arabia -- And Its Global Effects?

This week’s report that the Capital Market Regulator in Saudi Arabia will ban Deloitte’s firm from auditing public companies there as of next June 1, on account of its work for the targeted loss-making company MMG, will not be going down well for the largest of the global Big Four accounting networks.

Much more ominously, a collateral outcome of the Saudi black-ball may be the long-feared destabilizing of the Big Four’s trust-based franchise to audit the world’s largest companies, by a disruptive event in a location mistakenly assumed to be peripheral.

It has been well-enough recognized, since 2002 when Arthur Andersen’s leaders fatally failed to placate the US Department of Justice over conduct related to Enron, that it hurts to be on the wrong side of angry life-or-death power. Conversely, there are ample examples of the Big Four’s escape from scrutiny in settings too small to be consequential.

It’s the combination that is dangerous: an authority without a mature history of regulatory predictability, but with enough influence to unsettle the Big Audit model.

For some illustrations:

• In 2000, the Italian antitrust authority had the then-Big Six firms dead in its sights, with charges of price-fixing and other coordinated anti-competitive conduct. Lacking either the will or the motivation to push for practice prohibitions or other changed behavior, however – and who knows about “Italian justice” -- the agency was content to tap the firms gently on their wrists.

• PwC’s firm in Russia spent several years in litigation over its 2002-2004 audits of Yukos, under potential threat to its license to practice. But as now reported, PwC having remitted its fees to the government in settlement, it is comfortably persona grata, as shown by its engagements for Gazprom and Sperbank.

• PwC also suffered the inconvenient protracted incarceration of two of its Indian partners and their lengthy criminal trial, over the billion-dollar “ghost employees” scheme confessed in 2009 by Ramalinga Raju, founder and CEO of Satyam Computer Services. Results of the trial are expected at the end of this month. But it would seem unlikely that PwC‘s global chief Dennis Nally would have travelled to Delhi last month to head up his firm’s vigorous pimping a Goldilocks view of the country’s economy under Prime Minister Modi, unless he was thoroughly comfortable that the expected outcome would not disturb his firm’s presence there.

What is important is that none of these countries are large and important enough to matter. The Big Four’s global networks could survive worst-case exclusion from local practice in Russia or Italy or India.

It could have been a different and life-threatening story, by contrast, if in 2006, the sanctions imposed on PwC in Japan for its work on Kanebo had not been so flexible. With the size and global connectedness of the Japanese economy, PwC dodged a fatal bullet, permitted to survive the forced closure of its local firm by organizing a new local affiliate – which came to absorb many of its personnel and, vitally, by which it was able to continue both local work for foreign clients and ex-Japan work for its clients there.   

Which comes back to Saudi Arabia – where, incidentally or not, Deloitte also audits the Saudi-listed telephone provider Mobily, another investigation target after profit cuts, a stock price collapse and the suspension of its chief executive officer.

What is now unknowable is how far abroad the Saudi sanctions will run. In mature regulatory environments, official enforcement would not cascade into private sanctions across a Big Four client list. Leadership of a CalPers or PIMCO or Vanguard would resist imposing a ban on one of the Big Four that would cause self-inflicted disruption to the companies making up their massive fund portfolios.

Could the same be said of the global holdings of the Saudi royal family?

Demonstrably sensitive to any suggestion of lack of transparency, Prince Alwaleed Bin Talal is the chairman of the Kingdom Holding Company. On his watch, Deloitte’s consignment to pariah status in his country must be of concern, for example, to Deloitte’s firm in the UK, as auditor of one of the Kingdom’s premier real estate holdings, the massive Canary Wharf development in London.

More’s to the point, it might safely be predicted that, if the Prince has any say in the matter, only if Riyadh freezes over will Deloitte compete successfully against the incumbents for audit engagements of such prize Saudi holdings as Citigroup (KPMG), EuroDisney (PwC) or News Corp (EY).

The rippling effects of Deloitte’s Saudi-originated punishment may be grave enough. Further, with the acute pressures on auditor choice and replacement arising from mandatory re-tender requirements in the UK, and the rotations mandated under new legislation in the European Union, the structural impacts beyond a single unpredictable country can only be … well … unpredictable.

 

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Government Assignment and Financing of Audits? The New York Times Offers a Poisoned Bouquet

“Full many a flower is born to blush unseen,

And waste its sweetness on the desert air.”

 -- Thomas Gray, 1751

 There are three good reasons to be both optimistic and thankful that the New York Times editorial of August 15, 2014 – calling for “a revamped system in which audits are paid for not by company management, but by fees that companies pay to a public entity for the purpose of financing audits” – will fail to achieve traction.

These are, in ascending order of significance:

First, any print release at the absolute nadir of the annual news cycle, on a Friday in the dog days of August – and on the widely-observed holiday of the Feast of the Assumption at that – is bound to be ignored as inconsequential.

Second, two key people are distracted and not listening. The Chairman of the Securities and Exchange Commission, Mary Jo White, has shown no more interest in the accounting profession than her predecessors. And in any event, White herself is teetering on her back foot; as the NYT itself only two days earlier put it, “she has disappointed a wide swath of would-be allies … whose opinions of Ms. White’s performance range from dissatisfied to infuriated.” 

While over at the Public Company Accounting Oversight Board, chairman James Doty is fully tied up with deciding whether or not audit partners should sign opinions for their firms or in their own names – a long-perplexed but basically trivial matter not worth the years of wasted effort. Meanwhile, Doty’s latest feat is an inspection protocol announced on July 18, 2014, with the audit authority in Denmark. A pleasant little country, Denmark, but so insignificant to the global capital markets that it has only five PCAOB-registered firms in all, including but three of the Big Four, while the list of countries where the PCAOB remains stymied is headed by the 46 registered but uninspected firms auditing the massive economy of China – where successfully evasive politics continue as slippery and entangled as a bowl of ramen.

Third, the NYT’s endorsement of government-administered audit assignments reflects either breath-taking naïveté or an incomprehensible and unworthy lack of understanding of the audit services market – one that has operated exclusively on the “client pays” model since privately-provided assurance was invented in the 1850’s in England and Scotland.

Not that the accountants are or should be free from critical scrutiny. Examples of legitimate current concerns include:

• The very acceptability of the accounting by Lehman Brothers and its auditors, EY, cited by the NYT editorial itself.  

• The personal conduct of a very small handful of their partners (e.g., here and here).

• The settlement announced on August 18 by the New York State Superintendent of Financial Services with PwC, imposing a $ 25 million fine and a two-year ban on certain consulting for New York-regulated banks, summarized by the NYT as a “watering down” of a report on money transfers for blacklisted companies by Bank of Tokyo-Mitsubishi (and for a considerably contrasting description, compare Matt Levine’s Bloomberg View).

The large-company audit market continues under the near-total dominance of the Big Four – whose aggregate 717,000 personnel in fiscal 2013 generated $ 114 billion in global revenue for their 38,000 partners. For a government agency to assume the administration of the greater part of that sector of professional services – hardly a mere “revamping” – would present a catalog of challenges unexamined by the NYT and unaddressed by even the profession’s most rabid critics:

• What single-country government agency could evaluate and compare the global competence, resources and freedom from conflicts of auditor candidates in every one of the several dozen countries where a global-scale company operates and would require audit services?

• What costs and disruptions would the audit networks have to incur, to tender their credentials and proposals to such a government body? And how would their business model mutate, by way of talent and audit performance, if forced to deploy their resources to such a business-seeking process.

• Because government agencies are by their very DNA unable to resist political pressures, what would be the impact of the inevitable lobbying on behalf of small and minority firms, lower-tier accounting school graduates, and population groups under-represented in the profession?

• Would auditors bid for appointments? And if so, what pricing mechanism could be functional to provide transparency and integrity?

• Or would engagement assignments be dispensed like government permits? And if so, what public confidence could be reposed in light of historical experience with the awards of broadcast licenses, mineral exploration rights and cable and mobile franchises?

• How would the constraints of government-dictated budgets and liability exposures be reconcilable with the need for engagement cost changes in light of judgmental decisions to modify or expand audit scope?

• In light of these and a host of other questions, how could a government-run process of auditor proposal, selection and monitoring possibly function on a schedule that would enable the delivery of audit reports both timely and informative to the community of interested users?

In short, what possible public legitimacy could an agency achieve, operated under the aegis of a government that has inflicted on its citizens such administrative monstrosities as the Internal Revenue Service, FEMA and healthcare.gov?

A robust public dialog has long been needed on the structure and the future of privately-provided large-company audits. Happily, with the overhang of issues like the above, if it does take place, it will not be in context of last week’s proposal by the New York Times.  

 

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