New In Chicago Booth’s Capital Ideas Magazine: Big Four To Big Three

I’ve written a longer version for Chicago Booth’s Capital Ideas Magazine of my blog post from July about new research from Chicago Booth’s Joseph Gerakos, associate professor of accounting, and Chad Syverson, J. Baum Harris Professor of Economics, “The Problem of An Audit Firm Market Exit”.

The article appears this month in the magazine: “What would happen if the Big Four became the Big Three?”

The longer length allowed me to dig into the question of whether or not capital markets could live with only three global audit firms. Jim Peterson, who provides some numbers on what it would take to take out another firm, thinks not.

I have to agree. But most think that encouraging the next tier firms to get bigger and more competitive could help now. Or that if another large firm was threatened, the smaller firms would merge together to form a substitute. There are two reasons why that’s not a viable contingency plan.

First, the current post- Sarbanes-Oxley regulatory regime plus the depth and breadth of coverage needed to audit multinationals under current auditing standards makes it impossible for bigger to be sufficient. The smaller firms would band together to have equivalent revenue and maybe headcount but would lack the infrastructure, geographic and industry depth and experience with auditing large multinationals that’s absolutely required.

Second, if ever such a scheme would have worked it would have been after Andersen’s demise. For myriad reasons it did not happen and that’s even though four firms were still viable. If the number goes to three, the remaining firms would be unwilling and unable to shoulder or absorb the leftover liability exposure, let alone step up quickly enough to keep the public company audits flowing.

The gulf in revenues and headcounts is widening between Deloitte/PwC and EY/KPMG. If the next firm to go is one of the two largest—Deloitte or PwC—the industry would be finished. (It’s the consulting, duh.)

Deloitte, in my opinion, is behaving like pre-Enron Arthur Andersen, thumbing its nose at regulators alike while it fights private and public lawsuits for its poor audit quality as well as shoddy consulting work. Deloitte is also collecting stern warnings, fines, sanctions, and bans all over the world from government regulatory agencies. The firm must believe it’s protected by its relationship as auditor of the Federal Reserve Bank and consultant of choice to the US Defense Department as well as trusted advisor to the Central Bank of England amongst others.

Perhaps for now…

Peterson’s estimate of the threshold to losing a Big Four firm are modest in comparison to the litigation threats that we know exist. The Capital Ideas article ends with this sobering thought:

If Peterson’s estimates are accurate, pending court decisions could threaten to turn the Big Four into three. That makes Gerakos and Syverson’s exercise seem a lot less like theory, and more like preparation.

Wake up.  Smell the coffee.