Lyceum – James Peterson, Author

by Tom Hanlon 

The Uncertain Future of the Big Four Accounting Firms

Jim Peterson has a message of warning regarding the Big Four accounting firms, and he has the credentials and experience to back that message up. Peterson was a partner for Arthur Andersen from 1985 to 2001, retiring one year before Andersen’s demise in the wake of the Enron scandal. Peterson emerged unscathed and has continued his productive career as a lawyer, a professor, and a writer and author, dividing his time between Paris and Chicago. But being a part of what was then one of the Big Five accounting firms, he knows the perils that accompany the big audit model. “Arthur Andersen was by far the most profitable and cohesively organized of the then five global accounting partnerships,” Peterson told accounting students at a January 21 accountancy lyceum. “The fact that it could disintegrate as rapidly and thoroughly as it did demonstrates that it not only could happen, but it did happen.” Yet, Peterson said, nothing has changed with the big audit model in the intervening years—leaving it vulnerable and fragile. “There are a set of forces that have conspired together to cause me, at least, to be concerned about the survivability of the model,” he said. He spells out those concerns in his book, Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms. He shared key concepts from the book, the ideas for which were initially generated in his newspaper column for the International Herald Tribune and later in his blog. “Nothing has happened fundamentally to that model to give us more confidence in the stability and robustness of that surviving quartet,” Peterson said. “When Andersen fell, the model went from five to four. Another collapse and the whole model goes. That creates some serious issues with what the future might hold under that kind of scenario.” Peterson shared a bit of audit history with the students, from the emergence of independent auditing with William Deloitte, who in 1849 became the first independent auditor ever appointed (for the Great Western Railway in London), to 1930s America with the passage of two foundational securities laws that paved the way for privately-delivered audits of US companies. “The structure and function of the audit report has changed very little since the time of Mr. Deloitte, and the language has little evolved since the 1930s,” Peterson noted. FOUR FORCES THREATENING THE BIG FOUR These four forces conspire to threaten the Big Four franchise, Peterson said:

• The pass/fail opinion (“Its value is distinctly limited, and that’s being generous; it effectively provides no value other than to provide the statutory requirement that it be there”)
• The gap between auditor performance and user expectations (“Large complex jobs and systems designed and run by fallible human beings unfortunately are unable to deliver the zero defects that the users and legal communities expect”)
• The hostile relations with regulators (“The relationships with audit regulators are as fraught and as hostile as they’ve ever been”)
• The “black swan” possibility (“The fourth and most fraught of the forces that stress this model is the prospect of a black swan litigation proceeding against one of the four firms on the scale of the impact of the Enron scandal on Arthur Andersen. Enron showed that it can happen”)

The International Association of Audit Regulators, Peterson said, says that 40 percent of public audits contain fundamental errors, significant audit deficiencies. “One of two things is going on,” he said. “Either the deliverable is so substandard, or you have a regulator off in la-la land devising its own measuring stick and then you have an industry trying to figure out what to do with it.” As for the black swan issue, Peterson said that a Big Four firm could withstand a large hit—but those firms could not survive a black-swan scenario involving massive litigation. “Deloitte settled the fall before last in one of the financial crisis cases,” he said. “They were within a week of trial with a damage claim against them of $7.5 billion, an amount that was a multiple or two larger than their breakup tipping point.” NON-SOLUTIONS PROFFERED Peterson delineated numerous ideas that have been proffered by commentators on the profession, terming these ideas “non-solutions”:

• New competition and Break up (“The idea that new global scale competitors should be amalgamated out of the existing firms or the Big Four should be broken into smaller units to increase competition is fanciful and not feasible. You wouldn’t be adding any competition; you’d just be creating smaller, weaker firms.”)
• Insurance (“There is a popular notion that the insurance industry would protect the large firms. But the insurance industry is not infinitely expandable, and since the 1990s the claims have gotten so huge that the insurance industry is not interested.”)
• Catastrophe bonds (“If the creative, innovative, aggressive people in the insurance industry thought it was viable, that bond would exist by now.”)
• Forensic audits (“If that kind of work were available, the profession would already be doing it.”)
• Outside capital (“Firms don’t keep that kind of excess capital around.”)
• Management replacement (“The idea of accepting outside gurus parachuting in to say ‘Thou shalt’ is a total nonstarter. This one got laughed at and went away.”)
• Liability reforms (“The difficulty here was a political one. There’s no expectation that our legislators are going to write forgiveness for our profession.”)
• Government takeover (“It’s tough to imagine the creation of a government agency with the scope and confidence to carry out the type of multinational deployment of resources required to get out a set of financial statements.”)
• Mandatory rotation (“I’m amused by this because this concept, that fresh eyes will lead to better quality, is not true anywhere else in life. No research shows that there’s any relationship, causal, coincidental, or otherwise, between length of auditor tenure and the quality of the work. It’s an insult to say that short-term auditors will produce better work.”)
• Too big to fail? (“The question has been advanced regarding the Big Four whether they’re too big to fail. I think the better question is if they’re too frail to survive. The proposition that law enforcement and regulators will give the firms a pass fails on political grounds. Agencies of law enforcement are charged to faithfully carry out the laws.”)

TWO PATHS TO CHANGE Peterson outlined two potential paths leading to change. “One path is catastrophic collapse of one of the large firms and the immediate consequential disintegration of the entire model along the scale of Andersen,” he said. “If that were to happen, some kind of big new audit model would necessarily emerge. It wouldn’t just be done on a blank page; the way evolution works, it would have to be built out of available parts. But it would look dramatically different from what we have today. “The alternative is a robust and comprehensive and holistic dialogue that engages all the players in this model. The participation of all of them is essential; no single component of this model is capable of evolving the model alone.” He added that such a dialogue is unlikely to happen, given the antagonism among the players and the interest that each has in preserving the status quo. But to deny that the threats exist and the potential for major upheaval is real would be foolish. “Wishing and denial are not strategies,” Peterson said.  “My own desire and hope is we can talk about these things in a candid way and with a serious look at where things might be going.” HOPEFUL OUTLOOK Even knowing all of that, Peterson remains hopeful about the future. “I deeply believe that this profession is populated by men and women of competence, expertise, good faith, good will, and deep devotion to the successful role of our profession in our society,” he said. “Society has enjoyed the contribution of accounting expertise since trade was invented. It will continue to be. The opportunities to participate in the evolution of these functions are large and open-ended and will call on the creativity and energy and capacity of those of you who have the exciting opportunity to be at this stage of your association with it.”