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Auditing the Auditors

Associations & Practice	2504 VIEWS
Associations & Practice
2504 VIEWS

Monday, July 06, 2020 / 03:57 PM / By CRAIG MELLOW of GFMag / Header Image Credit: GFMag

Recent audit failures are bringing new scrutiny to the dominance and business practices of the Big Four accounting firms.

The Big Four percolate through the ranks of the CFOs they serve and the regulators who monitor them, forming an old-boys-and-girls club instinctively resistant to outside tinkering. "Audit firms have the most incredibly extensive alumni network in industry and government," Landell-Mills says. "It becomes quite incestuous and concerning."

Strong words, and more, are being hurled at the global accounting establishment these days. A recent UK House of Commons report on the collapse of sprawling construction contractor Carillion derided auditing's Big Four-Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers-as a "cozy club incapable of providing the degree of independent challenge needed." Carillion went into liquidation owing creditors Â£1.5 billion ($1.9 billion), despite its accounts having been cleared by Deloitte as internal auditor and KPMG as external auditor.

In the US, a surprise $15 billion charge related to General Electric's insurance business prompted 35% of shareholders to vote against retaining KPMG, its auditor for more than a century.

That came a few months after six KPMG partners were indicted for eliciting confidential information about pending inspections from the industry regulator, the Public Company Accounting Oversight Board, and the Federal Deposit Insurance Corporation won a federal lawsuit against PwC for its failure to detect $2.3 billion worth of fraud at an Alabama-based bank that later failed. PwC faces hundreds of millions of dollars in damages.

Elsewhere around the world: KPMG faces potential criminal charges in South Africa over its long-running relationship with the Gupta family, who are close to former President Jacob Zuma. Ukraine's largest bank, PrivatBank, is suing PwC for $3 billion, accusing the firm of turning a blind eye to massive loans-secured with questionable collateral or outright fraudulent-doled out to the institution's former private owners. And so on. "It feels like we've had scandal after scandal, and auditors rarely seem to be held to account," says Natasha Landell-Mills, head of stewardship at London-based asset manager Sarasin & Partners.

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Challenges of Reform

Railing against the accounting status quo is a lot easier than usefully reforming it. Informed governance advocates see the most knee-jerk suggestion arising from the Carillion debacle, "breaking up" the Big Four, as impractical and likely unwise. "The issue is not the number of accounting firms," says Paolo Quattrone, professor of accounting, governance and social innovation at the University of Edinburgh. "The issue is creating some tension and conversation among stakeholders."

But this should not lull corporate-finance officers and their auditors into the complacent conclusion that the current furor will just blow over. Regulators and investors, the sleeping giants of corporate financial oversight, are increasingly clamoring for audit reports that go beyond the classic "pass/fail" to detailed analysis of how various risks and intricacies are accounted for. They have the tools at hand in the "extended audit reports" that are already required (sort of) in the UK and European Union and will be phased in over the next few years in the US.

Outside stakeholders may start paying closer attention to the widespread phenomenon of auditors performing consulting services for auditees, though an outright ban on this lucrative practice looks unlikely for the moment. Companies can expect a push for stricter term limits on an s tenure, or at least competitive bids periodically. Anything like the 109-year run of KPMG and its predecessor organizations at GE looks set to become a red flag, if not a relic. "We're hoping GE is kind of a wake-up call on audit issues," says Jeff Mahoney, general counsel for the Council of Institutional Investors in Washington. "I don't think companies will be able to stand pat and do nothing."

The flaws of the current accounting order as a guardian of transparent global capitalism are obvious, if not glaring. The firms make far less money from audits than consulting. That undermines, to say the least, the ideal of an independent auditor shining a light on management's bookkeeping in the interests of shareholders and the broader society. "When you're an audit partner, you're really not going to push back on the client," says Christian Wolfe, pseudonym for an accountant in New York who contributes to the internal dissident website Big4accountingfirms.com. "In case you do push back, they'll go over your head and find somebody who won't."

Substituting one Big Four firm for another is unlikely to change this dynamic. "Auditing is effectively a captured market with a commodity product," says Karthik Ramanna, a professor of business and public policy at Oxford's Blavatnik School of Government who focuses on the subject. "The market conditions are such that they yield mediocrity."

Globally, the Big Four work through franchising or minority joint ventures. So, an office in South Africa, Ukraine or China bears the prestigious name, while the home-office partners are insulated from liability for its work. In all markets, "bean counters" who start with the Big Four percolate through the ranks of the CFOs they serve and the regulators who monitor them, forming an old-boys-and-girls club instinctively resistant to outside tinkering. "Audit firms have the most incredibly extensive alumni network in industry and government," Landell-Mills says. "It becomes quite incestuous and concerning."

But how to move toward audits that are more disinterested and effective, from a client's or broader societal point of view, is far less obvious. Looking beyond the Big Four for a smaller, more audit-focused player is a nonstarter under current market conditions. Virtually every company listed on a major stock exchange uses the established players, and for good reason. Tarnished as the Big Four might be, a non-Big Four auditor is a red flag likely to attract short sellers, says Wuyang Zhao, a professor at the University of Texas at Austin, who has researched this area.

Disentangling auditing from consulting work is a more promising avenue for reform, though also far from clear-cut. In theory, a solid "Chinese wall" between the two would lead to audits that are more at arm's length and are not an excuse to sell better-paying consulting contracts. "If I'm giving private tutoring to the same students I am evaluating, that's an obvious conflict of interest," Ramanna notes. The conflict has become more dramatic as Big Four consulting revenue has jumped 44% globally since 2012 compared to a 3% rise in audit fees.

But practically speaking, an auditor already steeped in the complexities of a client organization may provide better and cheaper advice on, say, IT system improvements or potential synergies with an acquisition target. The Big Four also use the promise of a future in consulting to keep junior auditors' noses to the grindstone, insider Wolfe says. "If you turn the firms into audit-only, the quality will be even worse, because you won't get the talent in there," he says.

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Regulators Bulk Up

The US is ahead of global peers in limiting audit-consulting crossover, thanks to the 2002 Sarbanes-Oxley law, which was passed in response to a number of accounting scandals, including the massive Enron and WorldCom accounting frauds. The profession has found enough loopholes in the years since that auditors add an average 25% onto their fees with nonaudit work. The comparable number for the UK is around 50%, while the EU allows up to 70% for non-audit add-ons.

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