Stories of crises make good headlines, but are usually vastly overblown, particularly where business is concerned. But it really does seem as if the Big Four accounting firms are approaching a potential watershed in their evolution. In this article, we look at the current issues and pressures and analyse the situation they are in through the lens of our Five Golden Rules of good corporate governance.
Scale of the problem
The four biggest accountancy firms are now huge businesses whose operations span the globe. They also provide an increasingly wide range of consultancy services and have long since left behind the days of accounting systems advice and tax-related services. As an example, one of the challenges facing WPP in the run-up to the departure of its chief executive, Martin Sorrell, was said to be the encroachment of the Big Four into advertising. This would have been inconceivable fifty years ago, and indeed could have led to the providers being struck off as Chartered Accountants.
This very range of services, coupled with the scale of the providers and the ability to deliver a wide geographical coverage, has meant that the risk of hitting embarrassing problems, or worse, has risen hugely. And indeed, that is exactly what has been happening. Here are a few recent examples to illustrate the global nature of the problem:
This US bank collapsed in 2009 and its auditor, PwC has been ordered by the court to pay a fine of $625m to the regulator, the FDIC, for failing to spot the fraud involving non-existent mortgages, which led to its downfall. This is apparently the largest award ever made against an audit firm.
After Steinhoff hit trouble,and shares lost over 98% of their value, auditor Deloitte faced a writ in a class action by disgruntled shareholders who charged that their audit fell well short of expected standards.
KPMG and its predecessor firms had audited Wells Fargo since 1931 and failed to pick up the scandal of mis-selling and creating fake accounts which blew up and resulted in the departure of the CEO. Shareholders and proxy firm Glass Lewis tried to get KPMG removed.
PwC was fined a record amount and reprimanded, and the senior audit partner involved banned from audits for 15 years after failings in its audit of retailer BHS, which went bust not long after.
Australian Bureau of Statistics
A whistleblower claimed that KPMG softened its report on the technology systems of the Bureau to suit the needs of the Bureau, whose future funding might have been prejudiced by an adverse report.
PwC was facing investigation into the scandal of improper accounting practices at BT Italy, which was uncovered by a whistleblower rather than PwC, the auditor. BT said it had overstated the profits of its Italian subsidiary by £530m.
Ernst & Young were being sued by a former partner, auditor of this Dubai firm, who had turned whistleblower, and revealed what he claimed were breaches of money-laundering regulations and buying gold from conflict zones. He said he was fired by EY after refusing to return to Dubai after blowing the whistle.
Politicians are never backward in spotting and exploiting an issue which looks damaging to the public, can generate popular appeal, and for which they think they can’t be held to blame. Firms going bust after clean audits, resulting in loss of jobs and damage to pensioners, where the directors appear to emerge unscathed financially, leads to a search for scapegoats. And beyond the board, the City elite, including the regulator and the well-paid auditors are a natural target.
This is well-advanced in the UK and the US, but is now starting to happen around the globe, from Australia to South America and Japan to South Africa, and the global accountancy firms are reaping the harvest of their global expansion. Hence in the UK a review has begun of the regulator responsible for Corporate Governance and in Australia a Royal Commission is looking into issues surrounding bad practice by the banks. In the UK the Competition authority is considering an examination of the position of the Big Four, and whether there is any benefit in seeking to break them up.
In turn, as a defensive move by the regulators, larger and larger fines are being levied on the Big Four firms following investigations which lead to condemnation of their audit practices in cases of company failure or misdeeds. And in the case of the regulatory body in the UK, it is being questioned whether the ICAEW can continue to combine the role of regulator of its Chartered Accountant members, while receiving fines imposed by the financial reporting regulator for members’ transgressions, and at the same time being the promotor of its members’ interests in the wider world.
Debate about the way forward
There is a debate among the interested parties about the way forward. At a recent discussion at Cass Business School on this topic, the range of views was on display. A board member of a global company expressed concern about the growing impact of politicians’ appeal to populism and the way it is leading to regulation being framed in “the court of the people” and secondary legislation being pushed through Parliament to avoid the full debate required for primary legislation. This is likely to lead to more layers of legislation, with the inevitable consequence of unforeseen side effects and bureaucracy, while failing to meet its supposed objectives of better governance.
An alternative view from a leading accountancy professor, was that big corporations have lost the trust of the public, and are accountable to nobody at the end of the day. So, in a world of no principles, principle-based regulation is always going to fail, and the focus instead should be on laws which are sufficiently detailed to make corporate leaders clearly and personally accountable for the behaviour of the companies they run.
Finally, the growing importance of the wider stakeholder interests and behavioural concepts such as diversity, as addressed in the UK Companies Act of 2006, was promoted by a specialist in this field. Her contention was that reporting to stakeholders as a wider group was now beyond challenge, and that companies need to introduce measures to determine the impact that their activities have on the society in which they operate. Of course, this trend is reflected in developments like MSCI’s ESG indices and the issue here is whether, and how quickly, the audit profession picks up the need to report on these wider issues.
In the debate generally, the response of the audit profession has been that companies won’t pay big enough fees to their auditors for them to do as comprehensive job as they might feel necessary to have a better chance of picking up each and every problem (not that they would admit that such was ever possible).
Does the Business Model still work?
It’s worth considering whether the business model for the Big Four accountants still works. Auditing is a mature industry and, as such, has all the corresponding characteristics, particularly strong competition (albeit from a few leading players) and low margins. The only compensation is that, notwithstanding mandatory limits to the number of years an auditor can stay with a client before the audit has to be re-tendered, the major clients are obliged to have audits , and they share their favours with just the Big Four. Hence, despite its low rate of growth, audit is a provider of work which keeps giving, and always to the same recipients. However, by comparison, consultancy is a growth industry and has much higher margins. Hence, therefore, the Big Four have been chasing revenue in this field for many years, to the extent that income from these wider sources greatly outweighs that from auditing, and generates better margins and the opportunity to create world-leading positions in new fields.
However, in addition to challenges about potential conflicts of interest, there is surely a bigger issue regarding the manageability of these sprawling organisations. Conglomerates have gone in and out of fashion (the latest being GE of the US), and no-one is yet describing the Big Four as conglomerates. But the issue of maintaining common high standards of ethics and professionalism must be a looming threat. What brought Arthur Andersen down was the unprofessional and unethical behaviour of the Houston office. The fact that the repercussions reverberated around its global organisation led the remaining big firms to create or emphasize structures which consist of an association of regional partnerships. In this way, a problem in one country – say KPMG in South Africa, can be isolated to a degree in that region without seriously threatening the global firm.
However, the corollary is that these assemblages of local or regional partnerships must be much more difficult to manage. And that problem is what has led to the break-ups of corporate giants in the past, or major re-thinking about the appropriate organisation and even purpose of these companies.
ACG Corporate Governance appraisal
Since the debate is essentially about auditing, not consultancy service, let’s look at the way the Big Four are approaching the provision of auditing against our Five Golden Rules.
Notwithstanding the worthy words of the leaders of the Big Four regarding their approach to business, and their commitment to learn from mistakes, there can be little dispute that the general perception (which is of primary importance to the public’s long term acceptance of their role as auditors) is that they are more concerned with revenue and profits than professional standards. That includes doing business globally with clients which are likely to take them into the grey area of questionable ethics. And as they say, a reputation takes years to earn and is lost overnight.
This brings us directly to the issue of who the auditor is working for. And strictly speaking it is the company as a legal entity which is the client. However, most people regard the auditors as working to safeguard the interests of the shareholders, albeit that this is gradually being extended to take account of the interests of a wider group of stakeholders. But where the contentious issue arises is the fact that the board appoints and pays for the audit, and to that extent the auditor is seen as, in reality, working for the management instead of the shareholders.
If the goal or purpose of the auditor is potentially conflicted, the strategy to achieve it must be similarly faulty. And, indeed, that brings us back to the discussion above about the business model. Is the emphasis on the growth of consultancy services fundamentally incompatible with the provision of audit services? There are, and have been, many people over the years who have argued precisely that. And even in countries where it is forbidden to provide both audit and consultancy to the same client, the organisation into larger firms which provide both, coupled with rotation of auditors, negates the professional purity which is intended by the separation.
Organisation resourced and structured to deliver the goal
We have discussed this above and concluded that the very size, global reach and range of services, when coupled with the structure of regional partnerships is likely to lead to a fragmentation of standards and inconsistency in best practice.
Accountability and transparency
This is, perhaps, seen as less of an issue, but, of course, these are private firms, accountable only to themselves, and the amount of information they need to release to the public is much less than would be required of much smaller public companies, with much less impact on global societies and economies.
The brief conclusion is that a purist would say that the current model is never likely to work very effectively, resulting in frustration for both the Big Four and for some of their clients, and for politicians and the general public when things go wrong, as they periodically will.
However, the solutions currently mooted, including breaking up the Big Four to create smaller (but similar) firms, supposedly to improve competition and therefore performance, is never going to solve the problem. Neither is the introduction of rafts of new detailed legislation and regulation.
Our answer, as we have said in earlier articles, lies in redefining what the audit is all about and changing the approach to carrying it out.