Systemic Risk! Dominance! Momentum! Auditors In Crisis. Again.

By Francine • Oct 15th, 2010 • Category: Latest, Pure Content, The Big 4 And Globalization

A movement to challenge the dominance of the big four auditors is gaining momentum with confirmation from regulators that many in the City back action to tackle the risks it has created…

You may think this quote is a recent one. It’s not.  It’s from more than four years ago.

Challenge to big four auditors grows

By Barney Jopson, Financial Correspondent, Financial Times, September 11 2006 03:00. A movement to challenge the dominance of the big four auditors is gaining momentum with confirmation from regulators that many in the City back action to tackle the risks it has created.

The Financial Reporting Council, the accounting watchdog, indicated that investors and companies, along with a significant number of accountants, had told it that the stranglehold of PwC, Deloitte, KPMG and Ernst & Young was unhealthy. Paul George, the FRC director responsible for its work on the big four, said: “There is enough consensus that there are risks associated with the current market structure and that there are things that can be done.”

In the past 12 months concern has intensified in the UK and beyond about the pernicious impact of the big four’s dominance on choice and quality in the audit market and on financial stability. The big four audit all but one of the companies in the FTSE 100 and 97 per cent of the FTSE 250. Their dominance is replicated in each of the Group of Seven leading industrialised economies…

Contrast that to the “outrage” expressed by UK and EU regulators and politicians during the past few months over the “dominance of the Big 4.”

UK Lords take long hard look at Big Four By Rachel Sanderson Published: July 27 2010 20:18 | Last updated: July 27 2010 20:18 The Big Four accountants’ dominance of the audit industry is facing mounting international scrutiny after the UK’s House of Lords launched a review into the firms’ role in the financial crisis.

But the debate is gaining renewed momentum in the US and Europe in the wake of the financial crisis amid questions whether the Big Four could have done more to alert investors about the risks in the banking system, and what effect any lack of competition might have had. The latest inquiry, by the influential Lords’ economic affairs committee, will be closely watched by regulators in US and in Europe, where Michel Barnier, EU internal markets commissioner, is holding a separate inquiry into audit competition.

The market concentration of auditors PwC, Ernst & Young, KPMG and Deloitte, which audit most of the world’s biggest companies, has been a matter of concern for regulators and politicians since the collapse of Arthur Andersen in 2003.

“Latest inquiry”

“Mounting scrutiny”

“Dominance”

“Lack of competition”

“Threatening quality”

“Gaining momentum”

“Systemic risk”

Blah. Blah. Blah.

Yadda. Yadda. Yadda.

Same words.  Only the reporters have changed.  Probably so they don’t bore themselves to tears.  FT is now on their fourth accountancy reporter, Adam Jones, in as many years.  But at least they have a semi-dedicated one on the beat, unlike other major media. Stephen Castle is the NYT EU correspondent in Brussels. He doesn’t have an accounting industry focus. This is his first story on the auditors this year.

E.U. Concerned by Big Four’s Dominance in Auditing, By Stephen Castle, October 13, 2010 BRUSSELS — The dominance of the four big global accounting firms faced a challenge Wednesday from the European Union, which said it would examine whether laws were needed to reduce their control of the market. Announcing an effort to tighten regulation after the financial crisis,Michel Barnier, the European commissioner for financial services, said that for the auditing sector, “the status quo is not an option.”

Mr. Barnier said that the big four — Deloitte, PricewaterhouseCoopers, KPMG and Ernst & Young — controlled 70 percent of the European auditing market, while in Britain, 99 percent of the FTSE 100 companies used them.

“We think that this sort of concentration can lead to systemic risk,” Mr. Barnier said, adding that the consequences if an audit firm went into bankruptcy could be severe.

He also pointed out that auditors, along with the rest of the financial community, had failed to foresee the onset of the financial crisis. “We need more competition. We need more diversity,” he said, suggesting that smaller accounting firms should be encouraged to expand.

Forgive me for being a bit cynical, but does the UK and EU also pop in new politicians every four years as we do here in the United States such that we get a fresh crop of potato heads every term, fresh from the field, with nary a clue about the history, legacy, machinations and pervasive influence of the largest global accounting firms? Do they think no one is watching and listening?  Have they any idea of the power of Google Search or the collective memory of everyone now chronicling their repeated hollow promises of reform?

The politicians trot out the same old ideas and suggestions for audit industry reform, over and over again. They wither on the vine, abandoned when something else captures the public’s attention and after the firms have performed their public relations and political contribution magic. Is there any other industry on the planet that toots their own distracting horn as much and as often about their charitable giving and “service” days as the Big 4 audit firms – Deloitte, Ernst & Young, KPMG and pwc – in every small town, medium size city, and major municipality where they have an office?

There have been numerous studies and periodic outrage voiced in the US, before and after the Enron scandal.  The current decibel level is not as high in the US as in the UK and EU.  The “outrage” over Ernst & Young’s role in the Lehman bankruptcy lasted about a month here.  Hell, we still haven’t seen any Congressional inquisitors call Ernst & Young to testify at a public hearing about Lehman or any other audit firm to testify about all the other failures, bailouts and forced acquisitions.

The Financial Crisis Inquiry Commission finally posted some documents from PwC with regard to the AIG failure.  The PwC partners’ names were redacted even though those same partners had been named as important actors in the resolution of charges against AIG’s Joseph Cassano.

My feelings about PwC and EY receiving long-term contracts to support the “internal controls” over the TARP program are well known.  Outrageous.  Two years later, the Congressional Oversight Committee has released their report, “Examining Treasury’s Use of Financial Crisis Contracting Authority.” Amongst other findings regarding conflicts of interest and lack of transparency or accountability in monitoring these contracts, I found that the names and rates of all parties involved in the accounting-related engagements, from partners in charge to on-the-ground managers to low-level staff, are still redacted from all published copies of the contracts.

If you didn’t think politics plays a large role on the ongoing “dominance” of the Big 4 and their free pass from serious accountability for their roles in failures, you only have to look at the new IASB appointment. A “statesman” rather than an accountant has been selected and the Chairman of the US SEC applauds this.

And then there’s the conflict of interest in appearance as well as fact for the new FASB Chairman Russell Golden.  I’ll let retired accounting professor and respected SEC reporting expert Tom Selling tell the story:

First, “insider” doesn’t fully describe the culture from whence Golden comes. As with far too many FASB staff members, Golden came to the FASB straight from the Big Four, where he was a technical partner who presumably lobbied the Board and its surrogates for the accounting rules his firm, Deloitte, proposed….

Second, Golden has a track record of catering to the Accounting Establishment. Notwithstanding, CFO.com reports that “Golden says he considers his point of view to be less that of an auditor and more of someone with an ‘open mind’ about improving financial reporting, which includes balancing investor concerns with the cost of improvements to prepares and auditors.” – but, I simply don’t see any evidence of that in Golden’s past actions…

Third, and this is the whopper, one Tracey C. Golden is a highly-placed partner at Deloitte. I had heard that Russell Golden’s wife works for the Big Four, and I guess this is she. The conflict of interest for Mr. Golden must be obvious, but since the Financial Accounting Foundation seems to have not given it much consideration, I’m compelled to spell it out:

  • If (as The Economist reports) Deloitte wants the FASB to converge with the IASB on loan and debt accounting, it is highly probable that this is also what Mrs. Golden wants;
  • If Deloitte wants to augment its book of business by assisting US companies in a mandated conversion from US GAAP to IFRS, then it is highly probable that Mrs. Golden wants IFRS and GAAP to converge wherever possible;
  • If Deloitte gets what it wants out of the FASB, then Mrs. Golden stands to become significantly wealthier, and so does Mr. Golden.

It may be no small thing for the Technical Director of the FASB, who has no formal vote, to be in a position to gain from the outcome of an FASB vote; because one might take comfort in the belief that voting members of the FASB will mitigate both the fact and appearance of a conflict of interest on the part of its Technical Director. It’s quite another thing, however, when the fate of the most consequential exposure draft in the history of the FASB has a nontrivial probability of being decided by the single vote of Tracey Golden’s husband.

I think Mr. Selling also agrees with me – and I suppose with the politicians and regulators who take up the issue every once and a while to score populist points – that the current audit model is irreparably broken. He recently repeated his key claims on a popular forum for accounting professors.  His remarks are reprinted by permission:

  • Auditors lack sufficient incentives to be objective (independence is a myth, and I don’t expect auditors to be independent).
  • Even if they were objective, audit reliability is questionable in two main areas:

1. Auditors are not valuation experts.  When valuations are called for, I believe that they should be made by third parties, and not management.  Auditor involvement should be limited to providing assurance that the third parties seemed to behave in an objective manner, and performed the procedures they said they would perform.

2. Verifying that highly subjective judgments made by self-interested management are “reasonable” – e.g., “probable” contingent liabilities, useful lives, salvage values, inventory writedowns, adjustments to the carrying amounts of receivables/loans, hedge effectiveness, functional currency determination, to name a few.

Most reasonable and intelligent people agree on these points. Most are also very concerned about the risk to the system if another large firm fails as a result of catastrophic litigation.  Many also acknowledge the serious threat to the quality and integrity of financial statements due to conflicts of interest and lack of  independence and objectivity inherent in the current for-profit audit firm business model.

The audit firms are no dummies. They have seen the potential for a backlash coming since the beginning of the financial crisis.  They knew it was just a matter of time until some populist politician took up the charge and they’d have to start defending themselves.  Time to turn on the smoke and mirrors machine and send out the proxies to counter the reforms they dislike with alternatives they probably won’t ever see.

It started in the UK back in early 2009. The auditors had been claiming a “good crisis.”

They fear that a blockbuster lawsuit, if successful, could put one or more of them out of business. That could trigger the collapse of the audit market and cause chaos for business, they say. All but two members of the FTSE 100 are audited by the Big Four…Last month, the US Securities and Exchange Commission (SEC), the American financial regulator, said that it would block any such deals involving British companies that were also registered in the United States.

The SEC fears that directors and auditors could cut secret deals under which auditors are given proportionate liability in return for glossing over the company’s accounts.

I wonder if the SEC still holds this position?

In another example of roadblocks to private rights of action in fraud and accounting malpractice cases, an ancient former SEC Chairman recently joined others who have played “Charley McCarthy” to the audit industry’s “Edgar Bergen.”

Former Chairman [Rod] Hills also urged the SEC to create a safe harbor for an auditor’s professional judgment. He emphasized that a plaintiff should not have the right to question an auditor’s professional judgment if the SEC and the PCAOB are happy with that judgment.

The last time I heard this one – that auditors should not be held accountable to investors for their “judgment” – it was positioned as a necessity in the event the US adopted IFRS.

Made me nauseous.

In the UK, the Big 4 have even convinced the “next tier” firms to beg for limitations on liability for the Big 4.  GT and BDO must have given up on ever bulking up enough to compete with the Big 4. Maybe they’re jockeying for a buyout.  Will we see more consolidation  - allowing Big 4 firms to buy BDO and GT, for example – rationalized by regulators as a way to insulate the industry from catastrophic claims?

Unfortunately, in the US, all of these concerns are addressed via the “too few to fail” policy – no large firm will be indicted by the federal government for criminal offenses, but civil penalties and sanctions will be meted out to culpable individuals only and only after many years of investigation when the story and the deterrent effect have been significantly diluted. Civil penalties against audit firms as a whole will be severely rationed.  The private right of action against audit firms will be constrained by the PSLRA, the Stoneridge decision, obdurate judges, and archaic legal doctrines that perpetuate the “we can be duped because we are simply humble bean counters and bookkeepers” defense. Settling cases rather than going to trial means juries and the general public will never see “how the sausage is made.”

It’s shameful.

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11 Responses »

  1. The author is correct. The audit profession is in dire straights. That is, the “PUBLIC” which the auditing profession is beholdent to is in even worse shape.

    What is the solution? Change the climate in which the auditors performs their work. Cut the cozy relationship between the entity being audited and the entity doing the audit.

    There is no question in my mind that the current method of the so-called INDEPENDENT CPA firm being paid by his client is inherently flawed. The BIG Four is structured to run on money as its fuel just as the economy runs on oil. We need an alternative fuel. Tinkering with the same old system will never solve the problem so long as the audotors work for their “CLIENTS” and turn their backs on their responsibility to the public.

    I left public accounting in 1972 because I did not agree with the ethics of my firm. In 1970, my staff found fraud in the subsidiary of a small local Houston bank. When we refused to issue an unqualified opinion, the client relieved us of our position as its auditorrs. To protect the firm, I locked the working papers in my desk. Six months later, the regional managing partner of my firm appeared in my office unannounceed. Incidentally, he was the immediate past president of the AICPA. He said he was here to regain the bank client that I lost. I suggested that he first look at our working papers and he replied that he did not need to do so; there were $30,000 of fees involved. A few hours later, he returned and stated that the firm had been retained again. The audit was to be performed by staff of my office, but I was not to have any contact with the job. He stated that the partner to be placed in charge was from the Chicago office. He had worked in my opffice for a number of years and was a partner in my firm before I merged. That partner was a classmate at Rice University of the bank president. He was his debate partner in college, and was best man at his wedding. Needless to say the bank did not survive. One of the seniors on the job, a former star student of mine when I taught at Rice University, told me that this partner came to Houston to run the audit, checked into a fancy hotel and ran the audit over the phone. AND, he gave the staff instructions to do nothing about the determination of the allowance for bad and/or doubtful loans, because he would set the amount required. That settled matters for me. Incidentally, over the years I had already learned of other similar situations.

    There is no question that we need change. The recent financial crisis in our country could have been curtailed if the auditors had honestly reported the truth. In its annual report for 2005, AIG published the Price Waterhouse Coopers audit report. Included therein was an absolute statement (as required by the AICPA) to the effect that AIG had accurately accounted for its derivatives. I wonder how much less the bailout would have been if this had been revealed in early 2006 or even earlier.

    The whole mess of the sub prime mortgage scandal; could have been revealed and curtailed if the auditors of the various lending institutions had revealed the facts. If you want to learrn more, please read my guest blog entitled “Sub Prime Auditing The Fox in the Chicken Coop.”

    There are a few ways to change the system. One is to have auditors work for surety companies. Clients would apply to surety companies for a financial health bond. The surety company would retain the auditors and pay them. Now I wonder what would happen if the auditors failed to do their duty. A second suggestion is to have all public companies pay an annual assessment into a national audit fund. This fund would be controlled by a board similar to the Federal reserve Board and appoined by th presidnt for reasonably long staggered terms. The audit board would engage the auditors and the auditors would be paid from the fund. I feel the first alternative is preferable. It is similar to the manner in whcih contractors protect their clients against loss. It also involves free enterprise in that the surety companies would be organized for profit. Entities being audited would be protected agionst unreasonable bond fees by having competition among the insurance companies. Incidentally, this has worked well in the land title insurance business.

  2. Now you’re talking. Here I go again, INCENTIVES COUNT! 34 years after the 1760-page “Metcalf Report” all Congress came up with is the laughably incompetent PCAOB! The PCAOB can do nothing to improve Big 87654 practice.
    What should we expect from Big 87654 bank auditors? Did not the Fed run “stress tests” to tell the public the 19 TBTF financial institutions were sound? Would the Big 87654 have the nerve to disclaim an opinion on a TBTF bank? Or the Fed itself? Did you read Deloitte’s Fed opinion?
    Businessweek recently reported the PCAOB sanctioned 32 CPA firms, one Big 87654 firm and 31 others. How impressive. All firms except the Big 87654 audit 1.2% by market cap of US stocks. The PCAOB must think they are the following relative threat to American investors: 31 / .012 = 2,583; 1 / .988 = 1.012; 2,583 / 1.012 = 2,552! Yes, the small firms like Beckstead are “not ready for prime time” in your world. The Beckstead’s and Kabani’s are 2,552X the relative threat to investors as the Big 87654! Ask the PCAOB.
    I say the PCAOB, subordinate to the SEC which in turn is subordinate to Treasury is a scam.

  3. Wow! Wide-ranging and thought-provoking (provocative is the better word) post on the audit profession, as usual! [And, I am not taking sides, as usual :) ]

    But, I do have one comment, on this sentence in your post: “A ’statesman’ [Hans Hoogervorst] rather than an accountant has been selected [as incoming chair of the IASB] and the Chairman of the US SEC applauds this.”

    There could actually be some benefits from having a ’statesman’ – if said person has sufficient experience and understanding of the role and impact of financial reporting and IFRS/GAAP on business, the markets and the economy – chair an accounting standard-setting board, particularly a board the size of the IASB, which currently has 15 board members, many with direct financial reporting/auditing experience, to be increased to 16 board members by 2012.)

    I believe some may say Hoogervorst has such experience (although moreso perhaps in terms of listed companies), by Chairing the Netherland Authority on Financial Markets (AFM) (analogous to U.S. SEC or U.K. FRC), serving as Minister of Finance, chairing the International Organization of Securities Commmission’s (IOSCO) Technical Commitee, and co-chairing the IASB-FASB Financial Crisis Advisory Group (FCAG). (His experience as Minister of Health, Welfare and Sport, noted in his bio on IASB’s press release http://www.ifrs.org/News/Press+Releases/chairman+appointment.htm , may come in handy too, as some may consider standard-setting or rule-making a type of sport in terms of ‘advancing the ball,’ etc.

    Additionally, on the ’statesman’ front, I would hope that the chairman of a standards-setting board would raise questions for discussion among the board as to whether proposed (existing) standards are (remain) practical, sensible, implementable, auditable, and understandable by practitioners, auditors, investors, analysts, and others (including regulators). Further, examination of these issues as they relate to small public companies and private companies in particular, in addition to large public companies, needs to be considered, due to their role fueling the economy and differing needs of the users of their financial statements (private co’s) and differing resources, constraints, and possibly different investor base (small public co’s).

    An interesting comparison can be made to SEC Chairman Mary L. Schapiro, who has what most would consider the key background to serve as SEC Chair, i.e. a law degree and experience as a regulator, including at the SEC, CFTC, and FINRA, I find it interesting that her undergrad major was in Cultural Anthropology; she discusses how background in that area has come in handy in her work at regulatory agencies in the first few pages of the transcript of an SEC Historical Society Oral History interview of her, which was conducted in 2005, here:
    http://c0403731.cdn.cloudfiles.rackspacecloud.com/collection/oral-histories/schapiro110205Transcript.pdf

    and in audio version/MP3 here:

    http://www.sechistorical.org/museum/oral-histories/s-z

  4. [...] sufficient remedies truly available to shareholders and investors if the states abandon them, too? [...]

  5. [...] The more successful a fraud case is against Lehman’s executives, the less likely EY or any of its partners will suffer any consequences for their acquiescence to or complicity in the fraud. That’s not to say the firm won’t suffer slowly and painfully from enormous amount of time and money devoted to defending Lehman litigation and the rest of the suits they face.  And, of course, there is reputational damage with some clients. That’s why their Chairman has gone on the PR defensive. [...]

  6. [...] all the world’s blue chip companies are audited by the Big Four, creating concerns among policymakers of growing systemic risks, particularly if one of them [...]

  7. Now we know that the Wall Street Journal got only part of the story correct. A WSJ article from a couple of years ago stated that Chrysler reassigned Bob Schott to an engineering and quality role from his role as CPO because Chrysler needed to improve relations with its suppliers. The article failed to tell the whole story, a story that is now a sequel at PwC. Bob Schott has zero tolerance for strong relationships and Chrysler finally cut him loose. As PwC often picks up the dirt, why not bring Bob Schott into the dump?

    In the few months that Bob Schott has taken over Procurement at PwC, he has interrogated partners and staff, demanded duplicative data and reports, failed to learn the partnership culture, refused to understand and learn supply chain complexities, tarnished global relationships and pissed off many people. But, what does that matter? As the golfing buddy of the CFO, so what if the firm goes through another productivity debacle? Isn’t it better to produce a change for the sake of change rather than consider the best practices in place? PwC is notorious for these efforts all which cost its clients valuable money in resources and efficiency. The word is out on Bob Schott – he is another Gene Donnelly. And, we all have watched Gene’s career escalate at PwC, right? Not. So, go ahead, Bob, keep it up. Your leadership, integrity and reputation are at stake and partners and staff are not turning a blind eye.

  8. [...] PwC has the most large, serious claims against them, including significant Madoff feeder fund litigation, as well as four crisis-era international fraud cases, Satyam, Glitnir, Yukos, and Landsbanki. And they’re still fighting litigation from AIG shareholders from 2001-2005 era.  But they’re winning in court lately, and so they may feel more optimistic about their chances of coming through all this with a “good crisis.” [...]

  9. [...] been much more noise made by legislators and regulators in the UK regarding the auditors’ role in the financial crisis than in the US.  Banks failed there, too.  [...]

  10. [...] been much more noise made by legislators and regulators in the UK regarding the auditors' role in the financial crisis than in the US.  Banks failed there, [...]

  11. [...] auditors were under siege in the UK, at least, and by Barnier for sure, long before they gave a revealing performance in front of the House of Lords Committee investigating their [...]

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