‘Big Four’ audit firms had a pivotal role in global financial crisis

Since the global financial crisis first erupted in the United States in July 2007, the group which has perhaps got off the lightest are the auditors.

I have a written several articles and blog posts questioning whether ‘Big Four’ accountancy firms — Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers — stoked up the crisis by signing off over optimistic valuations of bank assets prior to 2008.

See Creative accounting (4 December 2007), Finger of blame (12 October 2008), Which audit firm will go down first? (6 November 2008), Time to audit the auditors (8 January 2009) and Are ‘Big Four’ a waste of space? (5 April 2009).

In the first of these, “Creative accounting”, I wrote that the ‘Big Four’ “were so keen to get their hands on the scores of millions in fees they can earn for auditing major banks that they switched off their ethical antenna… Essentially they tolerated (or perhaps even promoted?) accounting methodologies that permitted the banks to deceive their shareholders about the true state of their balance sheets — for example through the widespread abuse of off-balance-sheet vehicles including SIVs and conduits and by valuing structured credit according to mark-to-model fantasies.”

In my April 2009 piece, which following the auditors feeble performance in front of the Treasury Select Committeee, I wrote: “The Big Four firms have become so commercialized and bluntly greedy that they have permitted their own organizations to become rife with conflicts of interest. Audits have been devalued and managements are rarely challenged.”

Basically the Big Four audit firms don’t want to rock the boat. If they did they might risk losing out on advisory and consultancy work  from the same corporate clients. It seems that no one has learnt any lessons  from the March 2002 implosion of Arthur Andersen, which made a fortune from cooking Enron’s books. And there’s a bizarre massed burying of heads in the sand about what caused the current global financial crisis.

Prem Sikka, professor of accounting at the University of Essex, who is often dismissed as a “maverick” but is one of my mentors on matters such as this, has gone a step further with an excellent article in today’s Herald. See The audit industry should serve society … not themselves.

Prem writes: “The auditors collected  £2142m in audit fees from FTSE-100 clients in 2002 to 2008 and a further £2159m for consultancy services to their audit clients  in 2008. They advised banks on the formation of special purpose vehicles, tax avoidance schemes, securitisation and structuring of transactions, all of which are central to the crisis

“They then audited the results of their own advice and inevitably said that all was well. When a whistleblower at HBOS drew attention to concerns about the risk profile of the bank, the auditors said all was well. The auditing firm received £23m in fees from the bank for audits and consultancy work ….

“Auditors of banks could not tell the difference between a tent on Brighton beach or AAA security. They too easily accepted management valuations and permitted banks to show toxic assets as good and report profits that did not exist.

“At least $5 trillion of assets and liabilities simply vanished from bank balance sheets. These audited accounts would easily have won the Man Booker Prize for Fiction. Yet no auditing firm has been investigated for its role in the banking debacle.”

He said the fitness of Big Four firms to audit banks “must also be questioned” and reeled off scores of scandals and financial crimes in which leading audit firms have been involved around the world. He added: “There is mounting evidence that poses questions about the integrity, effectiveness and independence of major accounting firms. The failures are manufactured by the organisational culture that prioritises profits at almost any cost.”

“The banking crisis is an opportunity to remove major accounting firms from the audit of banks altogether. Such audits should be conducted by a designated statutory regulator on a real-time basis.”

Three years of wrongdoing at ‘Big Four’ firm KPMG

• In August 2005, Big Four firm KPMG admitted to criminal wrongdoing over a multi-billion dollar tax fraud in the US and agreed to pay $456m in fines and settlements as part of an agreement with the US Justice Department and the Internal Revenue Service, who were timid about reducing the ‘Big Four’ to the ‘Big Three’. Six former KPMG partners and its former deputy chairman were criminally prosecuted for tax fraud conspiracy, relating to the design, marketing, and implementation of fraudulent tax shelters. Attorney general Alberto R Gonzales said: “The agreement requires KPMG to accept responsibility and make amends for its criminal conduct while protecting innocent workers and others from the consequences of a conviction.” The agreement imposed permanent restrictions on KPMG’s tax practice and banned KPMG from becoming involved with pre-packaged tax products. IRS Commissioner Mark Everson said: “At some point such conduct passes from clever accounting and lawyering to theft from the people.”

• In December 2006, Fannie Mae, the biggest US mortgage finance company, started legal proceedings against Big Four firm KPMG’s US arm in the hope of retrieving $2 billion. Fannie alleges that KPMG failed to serve its role as an independent watchdog and prevent accounting errors that led to $6.3 billion in accounting errors. That is over and above the $400 million KPMG has already agreed to pay the SEC to settle the regulator’s fraud allegations.

• In a counter-action, KPMG is suing its former client Fannie Mae for “fraudulent deception” which it says prevented it from uncovering $6.3bn in overstated earnings. KPMG alleges that from 1998 to 2004 Fannie Mae withheld and distorted its accounting, engaging in “breach of contract, fraudulent misrepresentation, fraudulent inducement”. KPMG says Fannie’s misrepresentation caused it to suffer “injury to its reputation, legal costs, exposure to legal liability, costs and expenses of responding to investigations” of Fannie Mae, and other losses.

• In June 2008, KPMG was obliged to pay a £495,000 fine and costs of £1.15m by the UK’s self-regulatory accountancy body, the Joint Disciplinary Scheme, for failing to complete a professional audit of collapsed insurer Independent Insurance. The JDS found that KPMG had failed to take steps to check suspicious information provided by Independent’s management during the company’s audit for the year ending December 2000. Some were surprised it took the JDS eight years to reach this conclusion and that such a token punishment was meted out.

• In August 2008, the US Public Company Accounting Oversight Board said that KMPG had failed to conduct proper evaluations and testing procedures to back up its audits of ten clients. The PCAOB cited instances where the firm should have performed additional tests to confirm its clients’ valuations and assertions, as well as to notice instances where a client had strayed from generally agreed accounting principles (GAAP).