The Problem Of An Audit Firm Market Exit: New Research From University of Chicago Booth School of Business

New research, “Competition in the Audit Market: Policy Implications,” by University of Chicago Booth School of Business Professors Joseph Gerakos and Chad Syverson says an unexpected market exit of any of the Big Four audit firms would result in substantial losses in client companies’ expected “consumer surplus.”

What is “consumer surplus”? That’s defined as companies’ value of purchased audit services in excess of the fees paid for them—that is, the net benefit derived from the audit services.

Gerakos and Syverson explore the effects of two potential ways a global audit firm could exit the market:  a) further supply concentration due to one of the “Big 4” auditors exiting and b) mandatory audit firm rotation. They estimate that, conservatively, client companies’ consumer surplus, the total dollar amount client firms would have to receive in order to be indifferent to losing the ability to hire the exiting auditor, would be between $1.2–1.8 billion per year depending on which of the four auditors exits the market.

Audit firm rotation has been the subject of much recent discussion both in the US and EU. The possibility that catastrophic litigation or a regulatory sanction could cause one of the larger audit firms to fold? Not so much.

In fact, there doesn’t seem to be any discussion of, or contingency plans for, the risk that regulatory actions such as the threat of de-licensing in a major hub country – it almost happened to PwC three times recently, in Japan, Russia and India – might cause disruption in the audit services supply chain for multinationals. Knocking out the supply of audit services from a major country is certainly one tool the PCAOB could use to limit the impact of bad auditing in China – although the prospect of de-registering all China-based auditors because of the regulator’s inability to inspect them and the SEC’s inability to get them to cooperate in a fraud investigation now seems more remote than ever.

Ever since the US DOJ effectively enacted its “too few to fail” doctrine, barring criminal prosecutions of audit firms after the Andersen debacle and its close call with killing KPMG during the 2005 tax shelter case – the US thinks it can control the risk of one firm losing the confidence of the market and being unable to serve its clients as a result of a failure or legal action in a US jurisdiction.

I’m not so sure they can control forever what goes on outside the US.

BTW, who is in charge of reviewing the firms’ global balance sheets, reserves for litigation contingencies, and assuring the capital markets that they remain viable? PCAOB sources have told me it’s not their job, and I’m not sure the SEC is taking a close a look at the financials of the firms inside, and definitely not outside, the US.

The firms remain overconfident in the face of serious litigation and potentially unlimited regulatory sanctions, in the UK alone for example, spending money “like drunken sailors” according to this piece today in the Financial Times:

As UK market leader, PwC has the most to lose. For instance, Unilever, the Anglo-Dutch consumer group, on Friday said it would drop PwC for one of its rivals after 26 years, citing “changes in the regulatory environment and market expectations”.

PwC received €21m from Unilever in 2012, making it one of the more lucrative audit contracts in the FTSE 100. It has already been displaced as auditor to both BG Group and Land Securities by EY, formerly Ernst & Young.

It may also face an uphill battle to keep Barclays – which it has audited for more than 100 years – given the desire of the bank’s new management to break with its recent chequered history.
PwC’s willingness to invest in the face of uncertainty reflects the strength of its partnership structure, says Mr Powell. “You can afford to take that medium and that long-term view.”

He admits that PwC’s audit dominance probably means it will lose more work than it gains from the shake-up. “We have about 38 per cent of the FTSE 100,” says Mr Powell. “In any retendering, in any rebalancing of an industry then it is likely that you are going to lose market share.”

But he adds that PwC’s audit arm is still growing, aided by “huge opportunities” at private and medium-sized listed companies. It is also looking to poach the HSBC contract – the biggest in UK auditing – from KPMG.
The firm will certainly win some new clients and retain some old ones as leading listed companies play audit musical chairs.

My post at Chicago Booth’s Capital Ideas blog about the Gerakos/Syverson paper discusses an example of industry concentration that is in the news now: ongoing investigations of bribery of Chinese officials by pharmaceutical companies, in particular PwC audit client GlaxoSmithKline.

Another situation where a potential auditor exit would have a big impact is highlighted by the recent bribery accusations against top-ten global pharmaceutical company GlaxoSmithKline in China. GSK has an active internal audit program and conducted a 4-month investigation of the bribery claims in China earlier this year as a result of whistleblower reports. But GSK, and auditor PricewaterhouseCoopers, are seemingly gobsmacked by extensive Chinese law enforcement accusations that local executives used travel agencies to channel bribes to doctors and government officials.

PwC also audits Sanofi (jointly with EY), Novartis AG, and Merck. BusinessWeek says these companies also used the same travel agency under investigation by Chinese authorities in the GlaxoSmithKline bribery and corruption case….

What might happen to global audit services supply if one or more of the cases PwC is involved with all over the world, including in the US, disables the firm – financially or as a result of regulatory sanction?

I shudder to think…