The independent audit franchise is founded upon the American securities acts of 1933 and 1934. But today’s audit model is not immune from the inevitable forces of change. Rather, it confronts a set of fundamental threats.
In a complex of interlocking relationships, the world’s large public companies issue their financial statements in accordance with nationally accepted codes of accounting standards, under the requirements of the overseeing regulators and stock exchanges, and as audited by firms of the Big Four international networks. Those firms dominate what I will call “Big Audit.” They serve substantially all the companies comprising the securities indexes of the world’s largest economies. Globally, this tetrapoly is made up of 40,000 partners and 760,000 employees, with aggregate annual revenues exceeding $125 billion. Yet nothing has happened since Arthur Andersen dramatically disintegrated in the winter of 2002 to suggest that the Big Four today are any more robustly protected against the very forces that destroyed Andersen.
The consequences of another large-firm collapse are no less dire today. Only the Big Four have the breadth of geographic coverage and technical expertise to serve the sector. The loss of any one of them would leave many large companies unable to find a replacement auditor; it would trigger the collapse of the entire model. That is—to take nothing away from the legitimate but limited capabilities of smaller firms—a “Big Three” structure would be unsustainable, under the constraints of globally imbalanced resources, conflicts of interest, and the prohibitions imposed by the rules on “appearance of independence.”
A set of interrelated forces define the fragile state of Big Audit:
- The traditional pass/fail auditor’s report has become severely diminished in value and credibility.
- A yawning expectations gap persists, which reemerges with every discovery of financial malfeasance.
- Relations between the profession and its regulators remain fraught with antagonism.
- The Big Four lack the organizational and financial capacity to withstand a shock on the scale that destroyed Andersen.
In the face of these challenges, an array of so-called “solutions” has been floated. Briefly, these would include:
- New competitive entrants at the scale of the Big Four
- Reversal of the insurance industry’s withdrawal of coverage at a level sufficient to provide sustainability
- Investment of third-party capital, which the Big Four do not need and could not usefully deploy
- Living will provisions to replace partnership leaders in crisis
- Stripping away the Big Four’s ancillary services, reducing them to audit-only firms
- Government takeover of the assignment, funding or performance of audits
- Mandatory rotation or retender of auditor engagements
- Protection from legal accountability in the form of “too-important-to-fail” liability caps or limitations on fines, judgments, or litigation awards.
But, for all the inadequacy of the above proposals, opportunities for the profession are rich—especially using “Big Data.” New and valuable forms of assurance—specially designed and focused on the needs and desires of issuers and users—are available for offer.
But today, Big Audit imposes the following handcuffs:
- Big Four partner income incentives to preserve the commoditized “pass/fail” opinion
- Liability constraints that inhibit innovation
- Independence conflicts that prohibit access to new client services.
Paths to Change
Given the circumstances, I believe there are two possible paths to fundamental change. The first would be the catastrophic collapse of the franchise of privately provided assurance. If another Big Four firm were to suffer Andersen’s fate, requiring a new form of Big Audit to be designed from the ground up, it could only be built out of the wreckage. The result would look very different from today’s model.
Alternatively, a robust and holistic initiative might engage the attention and the energy of all the players—a prospect that must be considered highly unlikely, given their mutual tensions and self-interested reasons for preserving the status quo.
Avoidance of the issues is not a strategy. Neither is a wishful hope that a catastrophic shock will not occur. No amount of denial or resistance can reduce the likelihood of another collapse. A healthy future for Big Audit calls for nothing less than participation of all interested parties. Adjustments in attitudes and perspectives will be required from everyone. Only vision and the will to act can prevent the crisis.