Tipping Point: The Financial Fragility of the Big Four Global Audit Firms
Criticism has been intense of Big Audit, for sure, but the tipping point to "the next Arthur Andersen" is not discussed in polite company.
“Predictions are difficult. Especially about the future.”
— Attributed to physicist Niels Bohr, or a Danish proverb
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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:
As the Big Four have admitted1 they 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.”