July 13, 2005

Accountancy Firms - too big to fail

Following the Arthur Andersen collapse, regulators in Europe have made their view known to their opposite numbers in the USA:

"Any reduction in the number of major audit firms could have negative implications, particularly for large companies in the U.K.," stated the U.K. Financial Services Authority, according to the FT. "We will be watching these developments very carefully." An unnamed European Commission official also told the publication: "It was already an issue going down to four [big accounting firms]. Obviously, having only three would be an even bigger problem."

KPMG has been declared too big to fail, thus bringing the big 4 auditors into the very select club of state-protected firms. The problem with this is of course the message that it sends to the world of accountancy. "If we can not be stopped, then we can do what we like."

One has to put this in context - the United States Department of Justice has taken on a tax case against KPMG. To ease the pressure against an expected DoJ indictment, KPMG has declared itself to be in the wrong (and thus made easier the costly process of civil litigation by the people they advised).

The big question is not about the particulars of the case but in how to regulate the market. The regulators are there and regulating; that's a fact, no matter how uncomfortable free market disciples find it. One of the rationales for regulation is that poor behaviour by dominating firms needs to be brought to heel. If as in some industries such as advertising there are no dominating firms, then the market can be expected to find its own solutions because the sector is spoilt for choice. However if the choice is limited to 4 large players acting in concert, we no longer have competition. Hence, regulation, so the rationale goes.

So in declining to bring KPMG to heel, regulators are simply undermining their own role. In choosing to not pursue KPMG to the fullest, they also choose to further weaken the viability of the audit in an efficient market by increasing the privilege available to the big 4.

Why not simply go back to the days of state-sponsored champions and declare auditing to be a protected business? The reason for this is fairly clear - regardless of the KPMG case and its predecessor Arthur Andersen, the big 4 audit sector has lost the faith of the public to deliver a viable honest service. Audits aren't trusted and for obvious agency reasons, so why are regulators bothering with both enforcing the use of an audit and letting the firms get bigger and more powerful?

(FC context - many systems are built with audits inserted to clean up the loose ends, as part of Governance. Now, if one starts from the point of view that audits are bad, one can actually do almost all the functions of audits internally and with ones own users, using modern FC techniques. But we still have to carry the cost of the mandated audit, which means that we are only interested in reducing the 'tax' paid to subsidised auditors.)

Posted by iang at July 13, 2005 08:55 AM | TrackBack

One obvious conclusion here is that - if big accountancy firms require a minimum of 4 operating to give a safe enough operating population, the goverment should be encouraging smaller firms to get together and submit tenders for large goverment contracts - to increase the number of viable alternatives and promote the growth of further competition.

I just don't expect to see it happen.

Posted by: Dave Howe at July 15, 2005 12:39 PM

"The regulators are particularly concerned that the outcome could damage an
already-concentrated audit market by taking out another major player..."

What is the key problem here? I'm not familiar with the corporate audit world. Are fewer large companies bad because of the scarcity it would create? The monopoly potential?

Markets are good because they encourage strategic choice? What are the strategic choices made by a company when hiring an auditor? If it is primarily cost-based, then presumably the (real) threat massive fines would help correct the market. Alternatively, prosecutors could adopt the practice of massively investigating every client of an accused auditor, which would presumably put a market premium on Squeaky-Klean-Audit inc.

To play off Dave's point, fines could go to the promotion of smaller firms. I worry about breeding a set of firms that handle government contracts as a specialty, since that seems like a good recipe for capture.

Posted by: allan friedman at August 1, 2005 05:39 PM

The nature of the concentrated market is probably a reaction against the power that the big auditers have, as well as intensive lobbying by the firms concerned. They are called the "Big N" because they can demand and get the big accounts; there is tremendous pressure on large firms and large government buyers to buy from the brand names, because that brand carries on to their customers.

There is a fear that if we go to Big 3 then those three firms will simply have more power of the type they exhibit now.

For example, there is the Sarbanes-Oxley affair. The big audit firms lobbied for this, and now it's here. The costs are clear, the benefits are not. Only the big auditors are clear winners in the expansion of what is basically bureaucratic territory. Nobody's much expecting this to stave off the next WorldCom, it's fighting the last generation's battles, so what's the point? And who were the people that did this to us?

Posted by: Iang at August 1, 2005 06:04 PM
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