Should We Embrace the Network Effect?

 

 

 

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Professor André Spicer

Is the extensive network of Big Four Alumni a problem in the auditing industry? Working with ex-big four employees can help large corporations to decrease information asymmetries. But it can also mean ex-big four employees are willing to pay a premium to be in the company of peers.Andre Spicer

An Inside Job?

It has long been a public secret that ex-employees are the best marketing tool for professional services firms. Management consultants, bankers, and advertisers (to name just a few) have a vast network of alumni work in in client firms. Sometimes these Alumni networks can be vast. For instance, KPMG has over 27,000 ex-employees listed on LinkedIn in the UK. In many cases, professional service firms go out their way to build these networks through placing ex-employees in client firms. They are often far better than schools or universities at carefully managing their alumni networks.

Recently, this practice of professional service firms using their alumni networks has come under fire by government regulators. The UK competition commission has found that the Big Four auditing and accountancy firms have a vast network of ex-employees working in their client companies. 60% of audit committee chairs and 66% of CFOs had previously worked for one of the Big Four. In addition, the Big Four regularly place their ex-employees into client firms. While the reach of the Big Four into the largest companies is clear, what is less clear is whether this is a problem or not.

Decreasing the Chump Tax

Some think that the Big Four’s networks are not such a big issue. In a recent column in the Financial Times, Lucy Kellaway argued that we should ‘embrace the network effect’. This is because through close contact with an individual or group over time ‘you know exactly how hard they work, how straight they are, how often they screw up and, above all, whether they are charging a fair price for what they do’.

The fact that there are many ex-employees from the Big Four is actually a big plus because it gives the client companies insider insights into how their auditors operates and the potential tricks they may play. The biggest advantage is that it helps to transcend what economists call information asymmetries. This big gap between the knowledge which expert and non-experts have that allows those in the know to rip off the ignorant. It is like when we visit the mechanic. Most of us are chumps when it comes to mechanics. We have very little in-depth knowledge of they work and what might potentially be wrong. This means when our mechanic tells us we need to have the engine overhauled rather than just a small part replaced – we are often none the wiser. This imbalance of expertise clearly puts the mechanic in a strong bargaining position – they could rip us off if they wanted to. The result is that we often have to pay extra for being a chump.

So how is it possible to decrease this chump tax? Clearly, the rational thing to do is to get an expert on your side. For instance, if we were advised by a relative who is also mechanic, it is less likely we will be ripped off by our own mechanic. In addition, if this relative has actually worked for our erstwhile mechanic, it is even more likely we could tell whether a new part was needed or not. The lesson here is that by balancing up not just expertise but also experience, it is possible to decrease informational asymmetries and the additional costs which are levied on chumps in a market.

This is exactly what large companies are trying to do when they hire an alumni from one of the Big Four. They are buying the alumni’s knowledge of how the Big Four actually work. This kind of intimate knowledge has a range of potential benefits for the clients. Because they know what to look for, it helps them to more effectively select competent auditors. Because clients know the price structure, they are better able to negotiate with audits. They share a common assumptions and ways of thinking which can facilitate the working relationship with the auditor. Finally, knowledgeable clients are more effectively police their auditors.

Paying an Identity Premium

Working with the Big Four alumni clearly helps to decrease the costs of client’s lack of expertise in the area of auditing. However, working with ex-insiders can come with significant hidden costs. One of the most costly is the identity premium. To put this simply we are often willing to pay an additional price to be around people who are like us (or at least who we aspire to be). This is clearly evidence when we choose items of status based on consumption like opera tickets, pricey schools or houses in ‘nice’ neigbourhoods. However, it is also the case with altogether more sober goods. Companies are often willing to lavish resources on new managements fads and fashions that make little difference to the bottom line to show that they are keeping up with ‘best practice’ in their industry.

So how does this identity premium apply to something as unsexy as audit services? Directors of audit are often willing to pay a premium to be in the company of people who are like them. If they come from a Big Four back-ground then they are likely to be willing to want to work with auditors ‘like them’ (i.e. auditors from the ‘Big Four’). By buying in people who are similar to themselves, CFOs or members of an audit committee are purchasing a sense of certainty and comfort which comes from being around your own kind.

 Big Four Auditors are not just a kind of corporate comfort food. Retaining the services of the Big Four is a kind of status symbol. They allow a company can show that they are similar to their peers in the industry who also use the services of the Big Four. By using ‘the best in the game’ a company can also try to indicate it is also the best at its own game. Having the badge of a Big Four auditor on your accounts can buy a company (or at least its CFO) a sense of acceptability in the eyes of people who matter like investors and regulators. But like any status good – it can come at a premium price. 

Often the premium is obvious on the price ticket. Big Four audits are often more pricey than their smaller competitors and usually there are also hidden costs of Big Four audits. These include the cost of become a sales target (when the Big Four use the audit process as a foot in the door which is used to sell all manner of other business services), the cost of less competition in the industry (due to only a handful of players offering the services), and the cost of a relatively cosy relationship between auditors and companies. Sometimes these hidden costs are born by the company. But more often than not, they are shouldered by investors and society more generally.

André Spicer is a Professor of Organizational Behaviour at Cass Business School, City University, London.

 

 

 

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