Big 4 accounting firms — inherent conflict of interest.

There’s an inherent conflict of interest in the Big 4 accounting firms that is leading to regulators around the world (UK, USA, EU and Australia) to force them to split off/sell their consulting businesses so that accounting/audit work is clearly separated.

Why is this relevant to the Big 4 accounting firms now?

Well, for several reasons, the main one being the deep, inherent conflict of interest that is embedded into the Big 4 accounting firms combined with their capture of government and the regulators. No matter what they say, how they try to say it and who they lobby to support them in this, the Big 4 have a conflict of interest in undertaking the audits of listed companies while at the same time providing millions (tens of millions) in consulting services to the same companies.

As with many things regulatory (think banking regulation post the GFC) the Australian accounting firms seem to think they can mount a case for ‘being different’ from other peer countries and regulatory regimes around the world and in their case other businesses because of their country specific partnership structure.

Come on guys…there was even a passing reference in the 2019 Queen’s Speech to the conflict of interest in the accounting profession.

Through the Queen’s speech the UK government said that it would ‘develop proposals on company audit and corporate reporting, including a stronger regulator with all the powers necessary to reform the sector’.

‘These proposals,’ it added, ‘aim to improve public trust in business, following the three independent reviews commissioned in 2018.’

Her comments, of course, come off the back of the recent reviews in the UK by by Sir John Kingman, the Competition and Markets Authority (CMA) and Sir Donald Brydon. Sir Donald has published his independent review on improving the quality and effectiveness of audit, the Department for Business, Energy and Industrial Strategy (BEIS) is now considering the hundreds of recommendations from all four major reviews of aspects of the profession — the future of the Financial Reporting Council (Sir John), reform of the audit market (CMA) and the future of audit (the BEIS Committee).

If you haven’t caught up with this you should. I admit it’s not the most exciting reading you could probably do but it may well be the most enlightening. For one it makes a complete mockery of the front and rear-guard actions and statements being undertaken by the firms and their professional organisations here in Australia.

Unaccountable

I’ve been catching up on my reading recently and could not wait to read Mike Brewster’s 2003 book Unaccountable. How the Accounting profession forfeited a public trust.

Mike, a former comms director for KMPG in the US, now journalist, and was compelled to write the book post the Enron implosion followed by Waste Management, Cendant, Xerox, Tyco and WorldCom to name just a few.

Among other great insights Mike had the following to say (and it applies here in Australia as it does around the world).

‘CPAs are employed as auditors at accounting firms to examine public company financial statements and vouch for their adherance to GAAP, among other things. Their stock in trade was the truth — not any more.

‘They [the accounting firms] took on a service on behalf of the shareholder and turned it into an information gathering tool for the client so they could sell consulting services and rationalise higher fees.’

‘Their client service has moved to a point where they are advocating for them [their clients] to the point where the auditors are not independent anymore.’

Unaccountable is a great read and made me realise, again, that what’s going on here in Australia now is so far behind where the rest of the world is in terms of the separation of audit from advisory. I must admit I was shocked to read that by 2001 in the US more than 70% of accounting firm revenues came from consulting. How could the same firms possibly provide an independent audit function for companies, especially listed companies?

More critically, if the accounting firms were making their money from consulting what is the stature of auditing within these firms and how much focus did and do they put on audit, other than as a back door into creating lucrative consulting gigs?

Of course, here in Australia the conflicted role of the accounting firms in audit and advisory has been partially discussed in the recent Parliamentary Inquiry into the Regulation of Auditing (the report of which is due in March 2020) undertaken by the Joint Committee on Corporations and Financial Services.

While much of this is like watching paint dry the ‘accounting’ disasters of Enron, Waste Management, Tyco et al in the US provide stellar examples of the self-serving, arrogant and at times completely out of touch defence of the conflict of interest inherent in the audit/accounting nexus being promoted by the Australian accounting profession at the Inquiry.

But there’s more.

Throughout 2018–19 we ‘discovered’ that former partners of the accounting firms receive ‘retirement payments’ based on the profitability of their firm after they have left for a considerable period of time. I call this the corporate equivalent of a forever golden parachute. Leave the firm to make room for ‘younger partners’ and we’ll look after you…and keep you tethered enough to keep you in the tent.

This played out in terms of numerous ASX-listed company directors (or in some cased the company boards) issuing statements along the lines of ‘Yes X does receive retirement payments but no it’s not a conflict as they don’t participate in decisions re who the auditor should be’, or something along these lines.

OK, so if it was so acceptable and not a conflict why aren’t these payments noted in the Annual Reports of ASX-listed companies including the amount of the payment?

Partner ‘retirement payments’

Oh, but wait. Why would an ASX company director receiving such a payment do this when the head of the government’s body charged with oversight of the accounting firms (Bill Edge the Chair of the Financial Reporting Council, FRC) also receives such a payment?

Apparently, Bill Edge’s ‘retirement payment’ is not material and therefore not a conflict of interest, so said the Minister responsible for the FRC, as well as then Assistant Treasurer Stuart Robert (he of the $2,800 per month internet bill scandal and other transgressions) and the ‘new’ Assistant Treasurer, Michael Sukkar.

So if it’s not material why not err on the side of disclosure and report what the amount is? In Bill’s case we know what he’s paid for his role as Chair of the FRC, $100,540, but not what his ‘not material’ retirement payment is.

If his ‘retirement payment’ is anywhere close to or more than this, it’s material. If it looks like duck, quacks like a duck, well, then it’s a duck – there’s a conflict of interest.

Another intriguing thing about Australia’s regulation of the accounting sector is the rather odd fact that the FRC board is a Statutory Body under the ASIC Act. It’s key functions include:

“the oversight of the accounting and auditing standards setting processes for the public and private sectors, providing strategic advice in relation to the quality of audits conducted by Australian auditors, and advising the Minister on these and related matters to the extent that they affect the financial reporting framework in Australia.” An ASIC representative sits on the FRC board.

It is also responsible for appointing members to the Australian Standards Accounting Board and undertaking an Audit Inspection Program based on information provided by ASIC, CA ANZ and CPA Australia (that oh so doyen of corporate governance).

The scary thing in the FRC’s annual report noted that ASIC Audit Inspection Program Results for 2019 is that between 30 June 2015 and 30 June 2018 the ‘key audit areas with findings have increased from 19% to 24%.

To be clear ‘a findings means an auditor did not obtain reasonable assurance that the financial report as a whole was free of material misstatement.’

WHAT?! To clarify. ‘24% of the 20 audit firms reviewed (98 files and 347 audit areas) did not obtain reasonable assurance that they were free of material misstatement.

A quarter of ALL these audits. Are you happy investing in public companies where potentially a quarter of the financial reports you receive as a shareholder cannot be confirmed as free from material misstatement?

Oh, then the FRC annual report goes onto explain and describe how it’s working with the accounting professional organisations and companies to improve the quality of their reporting e.t.c after all this is part of their job, but really who do they think they are fooling. The Big 4 accounting firms don’t give a shit about the quality of their audits beyond what they have to sign off on about adhering to GAAP and other ‘requirements’. The fact that there’s really no effective sanction either through ASIC, FRC or their own industry associations just shows how far they’ve insinuated themselves into the very fabric of the regulatory structure they operate in.

And in November in its submission to the Inquiry the FRC said there was little evidence of problems with the standard of auditing in Australia and asked to be put in charge of researching and making recommendations about any proposed changes to the laws around auditing.

At this point my head just hurts.

So we have ASIC, who has a representative on the FRC Board, saying there are issues, the ATO saying there are issues and the statutory body in charge of standards and overseeing the accounting sector saying there aren’t any issues.

The current Senate Inquiry into the consulting firms is just finishing up and their report is due at the end of March (2024). The obfuscation of the consulting firm heads has been breathtaking and Luke Sayers (now of Sayers Group formerly CEO of PwC) is leading the pack.

To go back to the future I found this interesting reference in Brewster’s book from a speech given by the then head of the US SEC, Arthur Levitt, in 1996 on the critical role of accountants.

‘They are highly sophisticated, knowledgeable professionals. And they serve one of the most valuable functions in a capitalist society. Their stock in trade is neither numbers, nor pencils, nor columns nor spreadsheets, but truth. Accountants are the people who protect the truth.’

That’s not how I see them, what about you?

Just how many inquiries and reports will it take?

In 2002 the US the Sarbanes-Oxley Act created a powerful accounting oversight body (much watered down so it could pass at all). It now has the audit watchdog, the Public Company Accounting Oversight Board.

The UK has establish a new regulator, the Audit, Reporting and Governance Authority (ARGA).

In 2012 Greg Medcraft (then head of ASIC) issued his first warning about the quality of corporate audits in Australia. In 2017 he repeated his criticism at the end of his term with the observation that the quality of corporate audits was appalling and getting worse.

Worrying still is that ASIC who undertakes the audit inspection process will not reveal publicly who at ASIC carries out the audit quality reviews although at the Inquiry it said its inspectors were ‘recently retired audit partners from big four firms who have no relevant conflicts of interest’.

Great, we’re back to ducks again . . . the same ones, and there is also concern about what assessment process ASIC uses.

Separately in 2019 CA ANZ was unable to say when it last reviewed the processes of the big four because it did not ‘capture or report’ the information. CA ANZ which is partly funded through the membership fees of its big four members — Deloitte, EY, KPMG and PwC, also cited ‘an understanding with ASIC’ over its decision to not review the audit work of the big four. ASIC said it was unaware of any such agreement.

Linked to the quality of audits is the systemic tax risk the Big 4 are creating according to ATO second commissioner Jeremy Hirschhorn. Hirschhorn has delivered his views to the Big 4 firms in a speech titled Reflections on being a large market tax adviser. In it he notes:

The big four, because of their sprawling size and importance to multiple areas of the economy, can no longer operate as though they were boutique firms. It’s different when you are systemically important. It’s not just about making money.’

He also warned tax partners they needed to adjust the way they provide advice and the firms need to rein in hired gun and guru tax partners that come up with these overly aggressive tax schemes.

Soon we’ll have our own Parliamentary Inquiry recommendations, this after years of sub-standard audits and woeful, in effective oversight.

Just how many reports and inquiries from how many of our major regulatory-aligned countries do we need to have to tell us that separating the audit function from the advisory/consulting business is the ONLY way to remove the real and potential conflicts of interest created by the worldwide accounting profession for their own benefit, NOT the benefit of the shareholders in companies that they have a legislative requirement to be the auditors of?

Corporate capture

The corporate capture by the accounting firms of the regulators, regulatory process combined with the inherent conflict of interest that arises through ‘retirement payments’ to former partners of the Big 4 accounting firms is a risk to our business and economic environment.

To paraphrase William Dalrymple whose book The Anarchy about the East India Company:

Corporate influence, with its fatal blend of power, money and unaccountability, is particularly potent and dangerous.

By killing transparency and competition, crony capitalism is harmful to free enterprise and economic growth. And by substituting special interests for the public interest, it is harmful to democratic expression.

#KMPG #Deloitte #EY #PwC #accounting #ASIC #globalfinance #business #businessbooks #accountingstandards #FRC