The impunity of the Big Four auditors

By Felix Salmon
October 28, 2011
Agnes Crane makes a strong case that they are, in the wake of a very tough report from the Public Company Accounting Oversight Board about Deloitte.

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Are the big four auditors too big to fail? Agnes Crane makes a strong case that they are, in the wake of a very tough report from the Public Company Accounting Oversight Board about Deloitte. The problem is that the PCAOB has no real teeth: with the number of auditors already far too low, at four, no one can afford a potentially-fatal attack on any of them. And that gives each of the Big Four effective impunity when it comes to mistakes and lack of professionalism.

Not to mention the fact that the PCAOB itself is horribly conflicted, as Jon Weil has discovered:

Three of its five board members had recused themselves from participating in meetings or discussions this year concerning Deloitte, because of past or current ties to the firm…

You have to wonder how good a job this board can do when a majority of its members can’t make decisions about one of the largest firms it oversees. No agency’s ties to the industry it regulates should run this deep.

Weil also points out that the PCAOB hasn’t even attempted to explain why it took 41 months to disclose its Deloitte evaluation; he might have added that we have no idea how many other, similar evaluations might be in the works.

I’m reminded of Jed Rakoff’s pointed questions for the SEC: what’s the point of regulating a company if you have no way of enforcing those regulations?

The dynamics at both the PCAOB and the Big Four are horrible. The incentive at the Big Four is to keep prices down to the point at which it’s impossible for a new entrant to break into their charmed group; after all, if it means they end up cutting corners, the worst that happens is that they get gummed by the toothless PCAOB. Even if they get broken up so that their consulting arms are spun off from their auditing arms, that still leaves only four auditors for most of the world of big business.

Is there a way of fixing this mess? Not an obvious one. Agnes says that “the only way to increase competition in the industry is for the incumbents to break into pieces”. But they’ll never do that voluntarily. And it’s very hard to see who’s going to force them.

6 comments

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I have a buddy who was involved in the Enron case (not on the criminal side). He still thinks the decision to give Arthur Andersen the death penalty was the worst decision he’s seen made in a case. The perps should have been put in jail, the company should have been fined like hell, but the accounting industry was concentrated enough (and conflicted enough) with 5 big firms.

Posted by AnonymousChef | Report as abusive

I think you may be misunderstanding the auditors’ actions (or at least interpreting them in the least-charitable light.)

Companies view audit services as a commodity – they push prices as low as possibly by playing one auditor off the other in price negotiations. As a result, there’s not enough margin to attract new entrants, the pay scale moves too low to encourage younger individuals from joining and remaining with the auditors long enough to build up expertise, and the scale advantages force consolidation amongst the players.

In short, it’s not that the audit firms force prices low – it’s that the market doesn’t differentiate at all between the auditors. I would put the blame on companies using their services, and thus ultimately to their shareholders for not demanding more.

Posted by worm600 | Report as abusive

The answer is very obvious…break them up. It would be easier than the break-up was for Bell Systems. Public accounting firms already operate as offices almost independent of each other, aside from consulting with experts on technical issues.

As far as audit firms keeping prices too low – I would argue that is almost impossible with an industry that relies so heavily on human capital. The only way to price gouge would be to pay staff less, which any firm is capable of doing. You’re real beef should be with the stigma that a public company must have a Big 4 auditor when there are perfectly good multinational or “super-regional” firms that are capable of providing the same service.

I am in agreement with the poster above me who says audits are a commodity. When you have a product that is the same as your competitor…marketing matters. Most audit firms keep clients through existing relationships or pursuits that require extensive face time.

To conclude, the answer is obvious…break em up and you’ll lose the “need a big 4 auditor” mindset and the risk of having an industry where all the service providers are too big to fail. You’ll get a lot of kicking and screaming in the short term, but the real impact wouldn’t be as bad as the fuss being made. You would end up with the same audit partners providing services to the same clients with the same staff. The only difference would be reduced efficiency from overhead departments.

Posted by smiller29 | Report as abusive

Couple of comments…

First, there is a term for this. It’s called “regulatory capture”, and refers to the fact that government agencies almost always have to turn to members of the industries they regulate to find employees. This is the case not only at the PCAOB, but also at just about every other regulatory agency in DC.

Second, the existence of these types of conflicts of interest is one of the better arguments out there for nationalizing some of these functions.

I would suggest that auditing large corporations, rating bonds, and calculating consumer credit scores are all such crucial activities that that the public would be much better off if they were done by government agencies rather than private entities in order to avoid conflicts of interest.

Posted by mfw13 | Report as abusive

I agree with mfw13 that regulatory capture is problem and it is so pervasive that fundamentally nothing is going to change until there is a crisis that will force change. What form that will take is to be seen but I have zero confidence in the government being able to right these wrongs because it is the corporate lobbyists who are effectively running the government. And they have a vested interest in maintaining the status quo.

Posted by Mbuna | Report as abusive

In terms of who can break them up .
Surely “we the people” can do it ?

Maybe the occupy wall street people need to add this to their agenda

Maybe the rest of us should not give up on democract and wring out hands in anguish

If we really think that breaking them up is important to a vibrant capitalist system we do have the power

d

Posted by DrHL | Report as abusive