Can the Big 4 Survive the U.K. Regulators?

Ed. note: Jim Peterson, a 19-year veteran of Arthur Andersen’s internal legal group, has been writing since 2002 about the issues and challenges confronting the Big Audit model, including as an occasional guest here.

Since last winter, Jim has been covering the intense public criticism in the U.K. of the performance and business model of the Big 4  firms—on his blog, Re:Balance, and in his new book, “DOA: Can Big Audit Survive the UK Regulators?”, published in May and available on Amazon in paperback and e-reader formats.

In a brisk and engaging 70 pages, he tells a story that in the U.S. is little reported and even less appreciated. What the Brits may do will have broad and disruptive global consequences—for the firms of all sizes, the users of financial information in the capital markets and elsewhere, and not least for students and faculty.

Jim’s book deserves attention, which is why we are posting an abbreviated excerpt of the introduction to “DOA: Can Big Audit Survive the UK Regulators?”.

Last year arrived for the Big Four in a winter of discontent and a torrent of criticism. In the UK, the trigger was the collapse on January 15, 2018 of the giant facilities and construction services enterprise Carillion. Audited by KPMG, Carillion had estimated liabilities exceeding £7 billion; according to the Competition & Markets Authority, “this collapse led to project shutdowns and delays, job losses, and financial losses, including to Carillion’s 30,000 suppliers, generating widespread public and political concerns.”

The US saw a $625 million judgment imposed against PwC for its audits of Colonial Bank, settled in March 2019 for $335 million, and guilty pleas and convictions for information theft at the PCAOB by agency and senior KPMG personnel. Scandals elsewhere included Gupta and Steinhoff in South Africa, the looting of the 1MdB fund in Malaysia, and the laundering of €200 billion through Danske Bank’s branch in Estonia.

Politicians, regulators and media were aroused. The inevitable question was pressed — “Where were the auditors?” In London, hostile critics urged breaking up the Big Four, stripping them of their non-audit services, or nationalizing the assignment of large-company engagements.

Official action was aimed at both the Big Four and their UK regulator, the Financial Reporting Council. Criticism from Parliament’s select Business, Energy and Industrial Strategy Committee was two-fold:

  • Regarding the Big Four, “The audit market is broken…. A host of solutions are now proposed…(and) it’s important that all options are on the table, including measures to break up the stranglehold of the Big Four.”
  • As for the FRC, its record was decried as “toothless and passive.”

Lengthy reports in December 2018 put the Big Four squarely in the cross-hairs:

  • On December 18, the committee headed by City grandee Sir John Kingman to conduct an Independent Review of the Financial Reporting Council issued its Final Report.
  • The same day, the Competition & Markets Authority advanced its Statutory Audit Market Study by issuing its Update Paper — further updated on April 18, 2019 by its Final Report.

The CMA’s Final Report endorsed two headline proposals — to require joint auditors for the country’s large public companies (¶ 4(b) and § 6), one of which must be a mid-tier “challenger firm,” and for an “operational split” of the Big Four’s audit practices (¶ 4(c) and § 8).

The BEIS committee on April 2, 2019, issued its own report — supporting the CMA’s proposals, and vigorously proposing more aggressive steps — among them full-on legal separation of the Big Four’s audit practices, enforced reduction and caps on their 97% market share of FTSE 350 audits, and mandatory seven-year limits on audit engagements.

For the FRC, the Kingman committee’s undertaking of a “root and branch” scrutiny of the agency called it (¶ 4): “a rather ramshackle house, cobbled together with all sorts of extensions over time… serviceable, up to a point, but it leaks and creaks, sometimes badly.”

On March 11, 2019, Secretary of State for Business, Energy and Industrial Strategy Greg Clark endorsed the Kingman committee’s recommendation to replace the FRC as the UK’s audit regulator with a newly constituted Audit Reporting and Governance Authority.

On a separate track, the Secretary also launched in December an Independent Review into the Quality and Effectiveness of Audit, led by Sir Donald Brydon, former head of the London Stock Exchange, “tasked with recommending what more can be done to ensure audits meet public, shareholder and investor expectations.”

With the official reports and proposals all out for public view, the intense activity of recent months has quieted briefly — to await further official action and possible legislation.

Can the Big Four survive the impositions and disruptions that the regulators and politicians in the UK may inflict? The issue is joined, the outcome is uncertain, the effects will resonate in markets around the world, and the consequences will be profound and disturbing.

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