August 21, 2018

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

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

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

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

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

On the basic but seldom discussed financial fragility of the Big 4 networks, her proposition picked up reinforcement from the Times of London on July 9, under the sub-head, “Litigation over a flawed audit could quickly lead to an Arthur Andersen-style collapse.”

This issue should not be new. Starting in 2006 in my “Balance Sheet” column in the late and lamented International Herald Tribune, I have been calculating the litigation “tipping point” that would disintegrate a Big 4 firm. Updating, the 2017 edition of my book, Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms, estimates those figures today at between $4 billion and $6 billion at the global level and between $1 billion and $3 billion for one of its U.S. firms standing alone—amounts falling somewhere between “modest” and “scary” considering the level of their exposures.

Is McKenna’s supposition of anxiety on the part of the profession that settlement disclosure might undercut public confidence a straw man? Equally arguable would be the benefit of public recognition that the business models of the Big 4—running on their client receivables and paper-thin capital—are simply not robust to withstand the shock of a truly “bad case” litigation or penalty.

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

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

The FRC or the Public Company Accounting Oversight Board in the U.S. could readily craft requirements that would compel such broad disclosure. Audits could even be required, drawing on the Andersen practice that its statements were audited and opined on by Haskins & Sells, as the Deloitte firm in the U.S. was then branded. Such a step would, however, involve a twist—both ironic and politically charged—that the only auditors with the scope and scale to report on a Big 4 network would be other members of that quartet.

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

As for any utility attributable to broad release of settlement information, “public awareness”—like movie temptress Mae West’s dismissive attitude toward “goodness”—has nothing to do with it. Competent management and audit committees, as well as any trial counsel with the skills and experience to litigate a 10-figure claim of audit failure, have the information needed to evaluate the soundness of a firm—both absolutely and relative to its peers.

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

The range of possible changes to the Big Audit model being tabled runs from the anodyne to the harmful to the laughably impractical—“open source” audit software, break up or spin off the Big 4 audit practices, or even fixed quotas on a Big 4 firm’s book of large clients (see the Times for July 9).

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

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

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

Jim Peterson was a senior in-house lawyer with Arthur Andersen for 19 years, leaving in 2001 to pursue his own practice and to write about the accounting profession—in the International Herald Tribune and now on his blog, Re:Balance. His book, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” was published in July 2017 by Emerald Books.

Image: iStock/alphaspirit

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