(Part Two) Tipping Points: The Financial Fragility of the Big Four
A Note from Francine McKenna, Editor:
It should be obvious by now that no government regulator, especially in the U.S. or U.K., will do anything to cause the aforementioned tipping point. In 2018, SEC Chair Jay Clayton went out of his way to say “nothing to see here” when he advised KPMG clients, investors, and the markets that he did not believe the civil and criminal charges against the five KPMG audit executives and one PCAOB inspector would “adversely affect the ability of SEC registrants to continue to use audit reports issued by KPMG in filings with the Commission or for investors to rely upon those required reports.” He also reassured investors and the markets that he did not expect the criminal indictments to cause interruptions in the “orderly flow of financial information to investors and the U.S. capital markets, including the filing of audited financial statements with the Commission”. KPMG had been saved once before, in 2005, and the whispered doctrine of “too few to fail” became a generally accepted reality.
That doesn’t mean private litigation and/or a rogue nation might not come out of the woodwork to break the humpty dumpty firms, just as we saw PwC suddenly facing three trials for audit negligence in an eighteen month span, with combined claims that would have been too much to bear. It was only after a judge found the firm guilty of missing a massive financial firm fraud and then imposed damages that were the largest ever via verdict for an auditor, that PwC was saved by the Trump administration and a new FDIC Chair that decided to settle for half of what it had fought for more than eight years to obtain.
The global audit firms are not above using heavy-duty political pressure to sustain their government-mandated franchise for delivering the public company audit opinion, an oligopoly that continues to provide profit for so many.
“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.
Earlier this week I updated the following 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 self-interests.