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Can the Big Four keep winning?

By David Walker

As accounting’s Big Four grow larger, their success creates new risks. Could the fairytale bubble burst?

The Big Four accounting and audit firms – Deloitte, PwC, EY and KPMG – are a remarkable global business success story. Their combined revenues now top US$130 billion a year. Collectively, the Four are growing at above 10% a year – faster than China. Together they now employ almost one million people, more than the Russian Army. Ian Gow, director of the University of Melbourne’s Centre for Corporate Governance and Regulation, observes that for businesses that are more than 150 years old and already dominate their core industry, such growth is genuinely extraordinary.

The Big Four have done more than just grow. Each has established well-protected positions at the centres of their territories, built out of audit assignments and tax compliance expertise and everyday accounting tasks. From these positions they have been able to sally forth and conquer the land of management consulting. They have made forays into the distant territories of legal advice and infotech. They have even ventured to the land of marketing, a place where it was once thought accountants could never set foot. Marketing academic Mark Ritson notes that “advertising executives have watched a slew of top talent exit their world to head over to KPMG, Deloitte and the rest”.

The Four’s victories in management consulting are instructive. All but Deloitte got out of the management consulting game in 2002 after the Enron collapse in the US.

Today, having returned to management consulting, the Four together hold 40% of this US$150 billion global market. Deloitte now makes more from that than it does from audit and risk advisory. All of the Four have prospered; they are now the four largest firms in the consulting business, and are acknowledged as leaders in everything from workforce management consulting to cybersecurity. As well as boosting their revenue and clout, this expansion into new fields is hedging their businesses against the long-discussed decline of their traditional audit and tax income streams.

Such a growth record seems no small achievement. Successful cross-selling is hard; just ask Australia’s Big Four banks, three of which are busy selling out of the wealth management business. So why are the Four not celebrated as business success stories?

That expectations problem

With journalist Stuart Kells, Ian Gow has now written The Big Four: The Curious Past and Perilous Future of the Global Accounting Monopoly. It explores their evolution from Europe’s Medici era through Victorian London to the current day and into the future. Gow admits you could argue with the term “monopoly” – but, as he adds, “between them they do own the auditing of large companies”.

The book provides a detailed look at the Four’s possible problems. Among them: the firms are vulnerable to overreach, their traditional markets are eroding, and they could face threats from digital analytics, blockchain and big data.

But right now, what imperils the Four more than anything is an old and familiar problem: high-profile corporate collapses. These have been going on since the 1720’s South Sea Bubble, but their recent rate is impressive. Every big company collapse has a Big Four auditor attached to it, and auditors continue to attract criticism for failing to foresee the collapses. As Gow and Kells note: “Lehman, Bear Stearns and Northern Rock all received unqualified audit opinions before their collapse.” Since then, we’ve had Satyam, Sino-Forest, the Olympus fraud, Hewlett Packard’s Autonomy debacle and more.

The latest corporate crater has been left by Carillion, the UK construction and facilities management giant which boasted 2016 revenues of £5.2 billion. It slid into insolvency in January of this year, overwhelmed by mounting debt and after months of stock market shorting. Investors, including large pension funds, are unlikely to see any money. KPMG audited Carillion, but each of the Four provided services of some sort. UK parliamentarians have begun asking why the auditors didn’t see trouble coming.

The MPs’ complaint is a textbook case of the famous “audit expectations gap” taught to every accounting student. Many in the public think accountants should detect looming disaster; the profession broadly believes that the public places an unfair burden on auditors in corporate collapses.

The objections to inflating audit expectations remain substantial. Gow and Kells note that “predicting bankruptcy requires skills and information well beyond those required to audit financial statements.” Indeed, it’s reasonable to doubt that anyone could really unwind the complexities of some of today’s businesses.

As academic Jacob Soll asked in his 2014 accounting history, The Reckoning: does PwC really understand about the vulnerabilities of Goldman Sachs when it checks the giant investment bank’s accounts each year? If the GFC showed anything, it was that not even these powerful entities themselves always understand their exposures. Four to three?

Amid the slew of collapses, court actions against the Four for their auditing work remain common. Gow and Kells see each of the firms as deeply vulnerable to such litigation. As partnerships (or, in KPMG’s case, a Swiss association) they lack the deep pockets of other large corporates. It’s surely reasonable to think that a lawsuit could eventually bring down one of the Four, particularly in light of their limited resources. Gow and Kells refer to “extinction-level events”, and point in particular to three:

  • In 2007 KPMG escaped indictment over its creation of tax shelters, instead paying a US$456 million fine. Gow and Kells report the US government scrapped an indictment because it feared a conviction would destroy the firm – but they add that “the decision could easily have gone the other way”.
  • US mortgage finance company Taylor, Bean & Whitaker, whose 2009 collapse – then the sixth-biggest in US history – triggered a US$5.5 billion lawsuit against PwC. This was the biggest claim ever made against an audit firm, they report; PwC settled for an unknown amount.
  • And, of course, just 16 years have passed since a giant accounting firm actually became extinct. In June 2002, in the wake of the Enron collapse, Arthur Andersen was convicted of obstruction of justice. Andersen’s US business dried up in weeks; the dying firm surrendered its CPA licenses before the end of August 2002, and its international practices were taken over by rivals. The obstruction-of-justice conviction was reversed on appeal in 2005 – too late for thousands of suddenly unemployed Arthur Andersen staff.

Then again, as Gow and Kells point out, US regulators are averse to letting the Big Four become the Big Three, simply on competition grounds. This is a classic “moral hazard” problem, with bad behaviour going under-punished.

But there’s an alternative to shrinking the Four: breaking them up.

The break-up scenarios

In May, in the wake of Carillion, Bill Michael, chairman of KPMG’s UK business, pushed this idea into the light. He used phrases rarely heard from a leader of the Big Four. “We are an oligopoly,” he told UK media. “That is undeniable.”

“I can’t believe the industry will be the same [in the future],” he went on. “We have to reduce the level of conflicts and … demonstrate why they are manageable and why the public and all stakeholders should trust us.” The increasingly consulting-based business model of the Big Four was “unsustainable”, he said.

And Michael added a remarkable detail of his firm’s internal strategy work: he said KPMG had been thinking about break-up scenarios for some time. “If you want to split the firms up, that has to be done internationally,” he explained, “although maybe the UK could lead the way.” PwC has also been reported as having a plan that covers scenarios such as a break-up law.

With Michael’s help, talk of breaking up the Four is growing louder; some UK MPs have called for it.

A break-up scenario could happen in two different ways: regulators could force each large firm to split into two smaller multidisciplinary firms; or the same regulators could make all of the Four spin off their consulting work to create audit-only businesses. This second option was backed by Stephen Haddrill, head of UK accounting watchdog the Financial Reporting Council, in February this year as a potential remedy for the lack of competition in the market. But, as Gow notes, it’s an untested solution; no large audit-only firms currently exist.

Few observers think either type of break-up is likely yet. But the fact that it is being discussed indicates how times have changed. Gow and Kells predict in The Big Four that “major change in how the firms are owned and structured is a likely feature of their future.”

The top 10 largest accounting firms by 2017 revenue

(year-end dates vary by firm)

Source: Firm statements

Surviving the onslaught

For decades the Four have been able to stay mostly in the background of the business world. They have no published accounts, no visible share prices, and the public perceive them as quintessentially dull.

But the growing revenue and reach of the Four is focusing more attention on their audit work, deepening the problem of the audit expectations gap – and deepening every other regulatory threat as well. The succession of leaks of huge volumes of tax-related data – LuxLeaks, the Panama Papers, the Paradise Papers – has also worked against them. As new KPMG Australia chair Alison Kitchen notes, there’s been a massive ramp-up in media interest. Banks used to be boring too – and look what has happened to their public image.

An explosion of analysis

Which may explain why since April we’ve had not one but two books focusing on the Four. The second, Bean Counters: The Triumph of the Accountants and How They Broke Capitalism, comes from Richard Brooks, a British financial investigative journalist for Private Eye and the Guardian.

Brooks doesn’t hide his scepticism about the accounting profession, calling the Big Four partners a “gilded elite”. But his accounts and transcripts of interviews with UK accounting leaders show just how little work the Four have done to convince the world they can learn from their mistakes. Brooks, writing before Bill Michael’s moment of Carillion-fuelled candour, comes to the same conclusion as Michael: that corporate consulting money will tempt auditors to “skew their thinking” so that the consulting fees keep flowing.

Gow and Kells raise the same conflict of interest issue in their book. They note that concerns on the issue stretch back more than 50 years. A US Senate report as long ago as 1976 concluded that consulting work was “incompatible with the responsibility of independent auditors”. Auditors could not cast an unbiased eye over their own firm’s work.

The Four argue that their consulting work improves their audit skills. Gow can see little evidence of a transfer of personnel between the two areas. As consulting work grows, the conflict-of-interest issue grows with it.

The Four may need a stronger defence against concerns such as these. They lack the corporate armour that even a bank has: the public simply doesn’t care about big accounting firms, and a firm’s collapse does not threaten the financial system. They barely have a political constituency outside the profession itself. And even inside the profession there are many who would be pleased to see them fall.

The reaction to the Arthur Andersen disaster is instructive. The world shrugged and went on with its business with barely a glance at Andersen’s smoking ruins or the shattered careers of so many professionals. If you help run one of today’s Four, it’s worth remembering that, in Gow and Kells’ words, “the Big Four’s accountability and advisory functions are highly contestable and substitutable”.

A regulator contemplating a bank breakup must worry about public confidence. The ending of one or more accounting firms, in contrast, would carry far less risk, even if it proved somewhat messy.

Yet complexity feeds the Big Four too. They may be vulnerable, but they have shown over the years a huge ability to beat their smaller competitors.

Adviser, disrupt thyself

KPMG’s Alison Kitchen has taken a good look at The Big Four’s argument. She sees no reason why the Four, with their record of success, should fall to the next wave of disruption. “Every CEO in every business we talk to says disruption is their number one issue,” she notes. “There is no reason we should be more scared about disruption than any other business.” Rather, she argues, firms like KPMG should disrupt themselves before rivals do. “Otherwise we’ve got no credibility.”

Indeed, in fields like management consulting, the Four have been able to disrupt the traditional top-end names of McKinsey, Bain and BCG. Over the past 15 years they have regained consulting scale. Acquisitions helped: Deloitte bought Monitor Group to form Monitor Deloitte; PwC picked up Booz & Company to create Strategy&. But the Four also sold clients on the value of providing both strategic advice and implementation. PwC and Deloitte are now the world’s largest consulting firms.

It is the long-established consulting powers who have been forced to play catch-up here. McKinsey’s managing partner in Australia and New Zealand, John Lydon, has acknowledged some clients’ frustrations at the difficulties of putting McKinsey’s advice into practice. McKinsey has now followed the Four into helping clients implement strategies over a number of years.

Alison Kitchen argues that business complexity is driving much of this change: businesses know they can’t do everything themselves, and instead decide “we’ll go and get a consultant in”. The Four have been the leading beneficiaries of that change.

Kitchen also believes the Four’s scale, depth of expertise and geographic reach are protecting them from smaller would-be rivals. She has a point. Despite ranking as the number five accounting firm by UK revenue, Grant Thornton announced in March that it would pull out of audits of FTSE 350 companies. The firm’s UK audit head, Sue Almond, declared with an air of resignation that audit work was “simply moving around the Big Four”.

The long ascendancy

Gow and Kells quote professional services expert David Maister as declaring that the “supermarket model” of professional services has been tried “in numerous industries and professions” and “discredited almost everywhere”.

Yet for the Four, the supermarket model continues to work.

In this game, scale and scope both seem to matter. No-one really can say why. So no-one can say how long the Four’s long ascendancy will last.

The answer cannot be “forever”. Yet for now, it seems risky to bet against the dominance of the Four.

David Walker has written about the accounting industry since 2012.

This article was originally published in the August 2018 issue of Acuity.