McKenna: Ten things you need to know about ‘Big Four’ audit firms

In Blog by Ian Fraser0 Comments

28 December 2010

I’ve long suspected that, at least where banking and financial sector clients are concerned, the ‘Big Four’ audit firms now see their role as being to pull the wool over investors’ eyes. The theory is about to be tested in the US courts, where Ernst & Young stands accused of fraud over alleged book cooking at failed New York-based investment bank Lehman Brothers.

The wide-ranging pre-crisis ‘negligence’ of PWC, Deloitte, KPMG and Ernst & Young — which included peddling Enron-esque accounting treatments, the burial of risk in opaque off-balance-sheet vehicles, and failure to alert shareholders to fraud — played a major part in inflating the credit bubble, and has been hugely costly  to both investors and taxpayers. For a flavour, see my earlier blog ‘Big Four’ admit deliberately misled markets pre-crisis

In earlier blog posts, I’ve made clear that governments and regulators should under no circumstances entrust audit firms with “independent” internal investigations into corporate crimes and misdemeanours on behalf of the above-mentioned interest groups. It’s a waste of time, as the Big Four’s natural instinct is to bury, not expose, malfeasance and fraud (see: The FSA wanted someone to whitewash RBS and sure enough PWC obliged). It’s fine if investors want a whitewash and are eager for endemic internal corruption and crimes to go unchecked. But otherwise, it’s a total waste of time and money.

Francine McKenna has expanded on the severity of the problem in an article on her Re: The Auditors site. Ahead of a session of the New York County Lawyers’ Association, Chicago-based McKenna marshalled her thoughts on the accountancy profession for the benefit of lawyers who, for whatever reason, remain unaware of the extent of the problem.

McKenna (who has given me permission to reproduce her blog post here), said that she prepared the list à la David Letterman: The Top Ten facts that attorneys – regulators, legislators, judges, defense and plaintiffs’ bar – should know about the ‘Big Four’ global audit firms:

10. The ‘Big Four’ audit firms don’t bother looking for fraud. Why? First, it takes time and money to perform a detailed fraud risk analysis. But instead of supporting fraud risk analyses, in the post-Sarbanes-Oxley 404 environment, CFOs are back to pressuring auditors to reduce their fees and to do more for less—instead of more for more. Second, senior management is almost always the source of fraud risk—but that’s who audit firms see as their client because that’s who pays the bill. Who loses? Investors and the capitalist system. How else to explain ‘Big Four’ audit firms as auditors of all the major feeder hedge funds that poured billions into Madoff’s fund and yet none of them saw anything, heard anything or said anything about the numerous fraud red flags so obvious to anyone like Markopolous that looked?

9. The ‘Big Four’ firms aren’t comfortable being watchdogs. They don’t even like being called watchdogs, in spite of a 1984 Supreme Court decision that reiterated their public duty. When an audit misses the really big frauds, the whoppers, their first move is to evade responsibility. The ‘Big Four’ don’t even like being called auditors. Rather they provide “assurance services, ” and act as “trusted advisors”. This isn’t just rhetorical. It’s a cynical PR move and an effort to limit their liability.

8. ‘Big Four’ firms should NEVER be asked to conduct internal investigations into alleged illegal activities for their audit clients. But companies continue to pull them into messy situations. A whistleblower, allegations of illegalities or improprieties, concern about corruption in a business unit… An auditor may be part of the problem. That means embarrassing and costly lack of independence. (Read, “E&Y at Lehman” or “KPMG at Siemens”).

7. You know what “global network” means. It means shifting blame. The audit industry is a profitable $100 billion revenue global business, employing hundreds of thousands of people. The “global network” is the legal vehicle the audit industry uses to drive liability around, in the ‘Big Four’ version of ”Catch Me If You Can.” Pick a legal entity to sue, any one, all of them and the ‘Big Four’ always win because they’re behind the wheel. Each so-called “member firm” and the global network as a whole is legally insulated from the actions of any other “member firm.” Even second-tier accounting firms use this tactic (read: “Grant Thornton and Parmalat”), but the bigger firms have it down to a (legal) science. They’re members and partners until trouble hits. Then, sayonara! Can you say PwC and their problematic Japanese – or Russian and Indian – firms?

6 (b). The ‘Big Four’ will never again be indicted for an audit failure. Indicting Arthur Andersen proved one thing: All you have to do to destroy a big audit firm is make one criminal indictment. The SEC, the DOJ, even the PCAOB all have acknowledged that they can’t afford the loss of another ‘Big Four’ audit firm. Why not? Because they don’t have a plan for ensuring the integrity of financial information for investors if the current model falls apart. And in this environment, who’s going to willingly wipe out 100,000 jobs? The audit firms hold a ”Get Out Of Jail Free” card, and they know it. They don’t fear being indicted. Individuals may be scapegoats (read, “KPMG and their tax partners” or “Flanagan at Deloitte”), but now the ‘Big Four’ have as much moral hazard as anyone. Unfortunately, the result is “assurance” provided by the walking wounded – firms so severely strained financially and strategically by billions of dollars of pending litigation that their leaders spend most of their time addressing, evading or settling claims instead of improving audit quality.

6 (a). “Final Four” means no competition and no straight answers. Ask a ‘Big Four’ audit partner for a ‘yes’/’no’ answer on valuation, for example, and you won’t get one. There’s only four global firms remaining that have the depth and global breadth to serve the largest multinationals. Each one is working for almost every bank on Wall Street and in The City in some form or another. Independence rules make walking this line a high-wire act. If not serving as auditor they’re advising on M&A or internal audit, or internal controls. They may even be implementing new financial systems. For that reason, they’re loath to criticize anyone or anything and more often will play Switzerland, staying neutral as long as possible, like PwC did between AIG and Goldman Sachs in one of the most notorious disputes of the financial crisis. Better, yet, just keep them out of the loop and everyone will be happy.

5. The auditors have a lock on the business. Case in point? Ratings agencies. Both ratings agencies and audit firms have a governmental mandate to provide a legally-required service. Both are paid by the clients they rate. And both repeatedly disappoint and even defraud the investing public. They aren’t in bed together, but they willingly endure sleeping with the enemy.

4. Why do the auditors support IFRS and mark-to-market accounting? International Financial Reporting Standards (IFRS) are supposedly on the way for the US, the last big holdout. Forget rules-based guidance, where it’s easier to say an accounting treatment is right or wrong. Principles-based guidance leaves wriggle room and a pretty sure shot at sneaking liability caps for the auditors in through the back door. They’re looking for a “safe harbours” for exercising their “judgment.” And, of course, any approach that causes confusion and complexity is the “next big thing” driving large fees for the firms. Any questions?

3. Campaign candy. The ‘Big Four’ firms spread the wealth on both sides of the aisle in Washington D.C., but the hand-outs always seem to be the ones with power to effect financial and regulatory reform. Does that reform ever go as far as it should? No. Should it have reached the audit firms at least this time? Absolutely. Did it? No way.

2. ‘Big Four’ firms have systematically avoided liability for audit failures. Audit firms are comprised of individuals who become accountants because:- (a) it’s a path to slow and steady financial success, (b) they’ve an affinity for details, and (c) they tend to be risk-averse. But they also work relatively autonomously, like a thousand franchise owners who are each expected to drive revenues and produce profits. So why are we shocked when:- (a) they are focused on fees and growing consulting services that make them rich, (b) they quietly but actively lobby for accounting rules that benefit their clients and laws that limit their accountability, (c) they use accounting rules (read, “special purpose entities,” “off-balance-sheet agreements,” “deferred tax assets,” etc.) to help clients justify almost anything, and (d) they are very good at avoiding liability and painting themselves as “victims” when they “miss” fraudulent activity? Isn’t this what they’re being paid for?

1. AND THE NUMBER 1 THING TO KNOW ABOUT ACCOUNTING FIRMS…

Lawyers are perceived as part of the problem. Most accounting industry professionals certainly don’t see lawyers as part of the solution. The SEC’s Enforcement Division is comprised principally of attorneys who formerly represented corporations. The audit firms are run by lawyers, internal and external, because they face a crush of litigation. Whether you serve them as defense or plaintiff’s bar, your clients the accountants would rather do their work quietly, collect their money and not be bothered with you. Can regulatory organizations dominated by lawyers not trained in accounting standards or familiar with the history of audit failures, and who have never worked for an audit firm, themselves be watchdogs of the ‘Big Four’? Lawyers are trained to advocate for their clients; audit firms have forgotten who their clients really are – the shareholders… Can lawyers influence auditors to do the right thing or has the accounting profession become too suit-shy? Do the SEC’s lawyers have the right attitude to effectively ”guard the guardians”?

Read Francine McKenna’s “Top Ten Things Lawyers Should Know About Auditors” in full on Re: The Auditors

See also Jim Peterson’s Disintegration of the Big Four Audit Firms? As They Tell the House of Lords, “We Don’t See That on the Horizon”

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