Britain is reeling from the meltdown of one of its largest public contractors – Carillion. The multi-billion-pound collapse has brought to light the extraordinary mess that is modern corporate auditing. We now know that Carillion was billed tens of millions by the so-called “Big Four” audit firms – Deloitte, EY, KPMG, and PwC. With so much spent by one client on accounting expertise, how did the company collapse under the weight of unsound financial-reporting judgments?
Of course, the Carillion debacle is not a new story – we’ve witnessed similar such accounting shenanigans before, for instance, in investigating the collapse of Enron and WorldCom in 2001-2 and the near-collapse of the economy as a whole in 2008-9.
After Enron brought down its storied auditor Arthur Andersen, new regulations were created with the intent to strengthen accounting and corporate governance practices. But more than 15 years later, we are still living with the same ailment – a dysfunctional audit market.
To see why, we can start by recognising that there are at least seven things wrong with corporate auditing today – perhaps, the seven sins of auditing.
First, it is a captured market – almost all major companies must purchase an audit. This takes away a prime incentive for the audit industry as a whole to supply and compete on quality. The audit industry knows that its customers aren’t going anywhere.
Second, the product that is sold – the audit – is essentially a commodity. It’s a plain vanilla report, with little nuance or texture. The auditor usually just says that given what they’ve seen, there’s nothing glaringly obvious at fault. This would be like a film critic simply saying that given what they’ve seen, a movie isn’t terrible. That’s not a very useful film critic. Now imagine if all film critics just did that. You really wouldn’t need film critics. Except, see point one.
Third, those who choose the auditors are not the ones who need their report. Auditors are effectively chosen by management and the board. But management and the board have access to inside information and, perversely, the incentive to cover up things that have gone wrong. The folks who really need audited financials include customers, suppliers, investors, and creditors. Many of these players went into business with Carillion on the basis of misstated audited financials. But they didn’t get to pick the auditor.
Fourth, auditing is an oligopoly. If you are a stakeholder in a major company, like a Fortune 500 firm, there are effectively only four players to choose from. The argument often given for this concentration is that auditing is complex and that there are scale economies to the financial assurance process. But corporate legal servicing is also complex, and there are plenty of law firms. So this argument may not stand up to real scrutiny.
Moreover, the fact that there are only four major audit firms means that regulators are often concerned about holding them properly to account. When Arthur Andersen collapsed after the failure of Enron, regulators were given some flak for turning the Big Five into the Big Four. So when KPMG was to be punished for peddling illegal tax shelters in 2005, an offence that could have cost the firm its license, it was slapped on the wrist with a “deferred prosecution agreement” – effectively a warning. Many worry that the Big Four are now “too few to fail”.
Fifth, there are serious conflicts of interest and ethical lapses in the auditing profession, across big and not-so-big audit firms. A recent report by the global agency that coordinates national auditing regulators has found ethical concerns in about 41 per cent of audit firms sampled. Think about that. Forty-one per cent of suppliers in a market for integrity are suspected of non-independence.
The big culprit here is the so-called market for non-audit services. Many audit firms, including all of the Big Four, make lots of money selling support services such as consulting and IT. As these services start to account for an ever-larger share of audit-firm profits, the core audit function can become a casualty.
But even beyond the issue of non-audit services, there are awkward signals on the ethics of the Big Four firms. A recent indictment by the Justice Department against several former KPMG employees reveals that these individuals were involved in illegally obtaining in advance their regulator’s plans for their firm’s inspection. One official involved in bringing the charges said: “these accountants engaged in… literally stealing the exam – in an effort to interfere with the [regulator]’s ability to detect audit deficiencies.” Even while KPMG as a whole has not been implicated, the case paints an unflattering picture of the firm’s corporate culture.
Sixth, the Big Four are politically powerful. Their power comes from their size and market dominance. They play an outsized role in setting the rules of their industry. For instance, they are amongst the largest financial contributors to the body that oversees the creation of international accounting rules. They also often enjoy a “revolving door” with their regulators. Employees of the Big Four sometimes take leaves-of-absence to serve as regulators; and cooperative regulators can find plush jobs at the firms. In the KPMG case above, an executive who was charged with “stealing the exam” went so far as to caution the connected regulator “to remember where [his] paycheck came from”.
Seventh, serious punishments for individual wrongdoers in auditing is the exception not the rule. The indictment of the KPMG employees described above is unusual. More often than not, prosecutors are unable to make criminal charges stick because auditors hide behind the veneer of their “professional judgment” and juries are reluctant to second-guess experts.
Through their power to write the rules of accounting and auditing, the profession has also attempted via statute to insulate itself from liability. On some issues, the rules excuse auditors from responsibility over their clients’ accounting estimates because such estimates are inherently unverifiable. This, of course, raises the question why the client firms are permitted to report such estimates in the first place? The audit profession has effectively engineered a system that allows it to socialise the risks of auditing while capturing the associated fees.
Before you conclude that the whole system is corrupt and we are better off without auditing, a word of caution. Capital markets need auditing. Without it, the financial reporting process will likely be a bigger mess than it already is. In fact, we’ve seen the “no audit required” movie before, and it doesn’t end well. Back in the roaring and unregulated 1920s, many companies did not supply audited financials. Their accounting gimmicks were implicated in the stock-market crash of 1929 that ushered in the Great Depression.
So how do we fix the auditing morass?
The first thing to recognise is that there is no easy fix. There is no simple five-point, 12-month plan. Perhaps the solution will involve dismantling the Big Four or splitting them into smaller entities, as was done with Ma-Bell in the 1980s. Perhaps it will involve creating a separation between auditing and non-audit services, akin to the separation between commercial and investment banking that the Glass-Steagall Act successfully effected for about six decades.
Whatever the solution, it will require navigating many moving parts. Given how integral audits are to financial markets, serious auditing reform will be like performing brain surgery on a conscious patient.
But if we are to reform corporate auditing, there’s one group whose help we must remain wary of – the audit firms themselves. They are likely to offer up their services. They did so in 2002 in the aftermath of Enron, as the US Congress considered new rules. The resulting regulation is sometimes pejoratively referred to as the Accountants’ Full-Employment Act, for its proclivity to create busy work (and more fees) for the industry. And given the complexities involved in audit reform today, governments may well be tempted to again take up an offer of assistance from the auditors.
A bad idea.
While this may seem obvious, recall how eagerly we accepted the help of bankers in 2008. No surprise, they bailed themselves out, first and foremost. If we are going to reform auditing, then there’s one lesson to learn from the financial crisis: Don’t trust the auditors to do it.