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Audit Market Caps In the UK: The Financial Times Fails a Math Test

“The Glacial Pace of Audit Reform Needs To Speed Up”

The Financial Times might wish to reconsider this headline, above its editorial of late last week.

Global climate change considered, the metaphor may be more apt than intended, as the likely fate of the world’s glaciers is their tragic and accelerating collapse into muddy puddles amid massive fields of rocky rubbish.

The trope would match the UK government’s belated and sluggish response to the tumult surrounding Big Audit in the post-Carillion era. There are two main efforts in its consultation of this March, “Restoring Trust in Audit and Corporate Governance”: a floundering attempt to construct a legitimate audit regulator to succeed the shambolic Financial Reporting Council, and a single substantive proposal directly applicable to the audit firms—“managed shared audits” for the FTSE 350 companies—an unachievable idea that has failed to attract any measurable amount of serious support.

The FT continues to urge a forced reduction of the Big 4’s dominance of FTSE 350 audits: a cap of 80%, within 10 years time—apparently recalibrating its earlier push for 60%.

For the premier English-language publication addressing business and the capital markets, with “Financial” as its very forename, it falls between perplexity and disappointment that the FT’s support for audit market caps pays no attention to the numbers—bluntly, that the very structure of Big Audit makes impossible the role that would be thrust upon the unfortunately-described “challenger” audit firms.

The facts matter. Here a summary, using the market capitalization of the FTSE 350 companies as a proxy to measure the demands of personnel and resources required to perform large audit engagements:

First, the FTSE 100, whose constituent companies’ total market capitalization is £1.814 trillion. Of these, the share of the “challenger” firms is zero. Of the far-smaller companies comprising the FTSE 250, their share is about 20—in flux although modestly expanded in the last year to some 9% of the total market capitalization of £394.6 billion or some £35.5 billion.

Combined across the two indices, the “challengers” hold an audit market share of the FTSE 350 by market capitalization of some 1.6%.

Into that reality, the growth necessary for the “challengers” to reach the 20% target urged by the FT may be measured in two ways:

  • Yearly for 10 years, they would have to add as clients a book of companies with total capitalization of some £41 billion—more than double the size of their collective total client base todayThat’s each and every year.
  • Or, as an English major with a calculator can compute, to spread capacity-building gradually over the decade, they would have to achieve a year-on-year compound growth rate of 29%.

To this bleak picture, little needs be added. The underlying reasons why the “challengers” have no growth path on that impossible scale do not implicate performance quality. It’s personnel, expertise, geographic presence, and financial and risk support.[1] The stark numbers themselves tell the story—it’s not going to happen.

Giving these figures no recognition, the FT presses a set of unlikely premises (all emphasis added):

First, the FT assumes a 10-year process “once the reforms are in place”—a benchmark unanchored to the unlikely fulfillment of the government’s plans at all. So far there is no evidence of the legislation necessary to transform the FRC—described by the acerbic Labour MP Rachel Reeves as “toothless and passive”—while her pungent description might well apply to the government’s own process, given its “glacial”—not to say backwards—movement on the basics of populating the FRC’s board of directors and filling the office of chairman.[2]

Second, the FT urges that smaller-company audits might be “assigned” to the “challengers”—a prospect inconsistent with the obligation on both auditors and companies that client engagement acceptance be at the mutual judgment and acceptance of each.

Third, the FT describes the Big 4 as “themselves split on the best way forward, though none is enthused by the government’s proposal for managed shared audits.” This, while perhaps not reaching the level of misrepresentation, mis-conveys what was more forthrightly surveyed by the FT’s own Michael O’Dwyer on August 15, that the Big 4 “have refused to back” the proposal for shared audits.

As reported by O’Dwyer, their message is clear enough, although if bobbing and weaving were an Olympic sport, the Big 4 would be medal contenders: with the candor permissible behind closed doors, the take on shared audits would be somewhere between “no” and “hell no.”

Fairly put, however, the Big 4 need not go publicly beyond the perhaps characteristic British euphemism. Given the UK government’s paralysis, their simply expressed distaste for shared audits—a position held in common with the business community and indeed at least some of the “challengers”—will adjourn any real confrontation with the impossibility of audit market caps to the arrival of the next global ice age.

Finally and most egregiously, the FT leaps to the position that “a transition period where challengers start to mature and incumbents give up a part of their dominant position is inevitable.”

No—it is not. Several scenarios, no less unappealing, are at least as likely.

A wager on the more likely to first occur: as between actual achievement by the “challengers” of a 20% market share, or (i) the collapse or failure of one or more of the “challengers,” under the weight of their over-hanging litigation and performance quality issues or otherwise, so that their sector falls below critical mass, or (ii) the disintegration of another of the Big 4, as doomed Arthur Andersen in 2002, which would bring about the total collapse of today’s Big Audit model.

If offered a voice, the world’s glaciers would opt for relief from the malign effects of human interference. No less, the inability of the editorial writers at the Financial Times to appreciate the actual structure of Big Audit impairs the value of their contribution to the discussion.

[1] For the details, please see my blog posts of April 21, 2021 and June 1, 2021, and the extended treatment in my book, “DOA: Can Big Audit Survive the UK Regulators?” (Amazon 2019).

[2] At this writing, the FRC’s interim chair is to leave in October, the full-time post being unfilled for over a year since its last occupancy for a mere eight months, while there are two new arrivals on the board and a second empty board seat (here).

[Ed. note: This article was originally published on Re:Balance on Aug. 23. It has been re-published with permission.]

Jim Peterson is a 19-year veteran of Arthur Andersen’s internal legal group. He has been writing about the accounting firms and the Big Audit model since 2002, on his blog, Re:Balance, and in his two books, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms” (2d ed. 2017) and “DOA: Can Big Audit Survive the UK Regulators?”