Updated 5 April 2009
From the evidence submitted to the Treasury Select Committee’s inquiry into the banking crisis, one might conclude that the profession of accountancy as practiced in the UK is past its sell-by date, clinging to the vestiges of power and influence by its fingernails and in urgent need of reform.
This tallies with what investment managers have been telling me for 12-18 months. They see the published accounts of most plcs as unconvincing exercises in puffery that can no longer be relied upon, and are disparaging of the beancounters who put them together.
In the session of the Treasury Select Committee held on January 28th 2009 (full transcript here), it became apparent that audits by ‘big four’ accountancy firms — PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young — are neither independent nor of much real value.
This is largely because, from the 1970s on, these firms “sold out”, becoming greedy and rife with conflicts of interest. Audits were devalued as a result of the auditor’s reluctance to challenge corporate managements any more. This is partly because the audits became a loss leader and the accountancy firms, who didn’t want to risk offending offend potential purchasers of more lucrative advisory and consultancy services. Clearly no lessons were learnt from the 2001 implosion of Arthur Andersen after it made a fortune from cooking Enron’s books.
There isn’t room in this blog for everything that was said during the committee hearing (and I have deliberately left out much of what was said by representatives of the accountancy profession — much of that they said seemed platitudinous and self-serving). I’d point out, however, that, even though the people questioned were accountants, heads of lobby groups representing accountants and professors of accountancy, the session made for a surprisingly interesting listening.
Prem Sikka, professor of accountancy at the University of Essex and a regular commentator on the Guardian’s Comment is Free site, was eloquent in his description of what ails the profession. At the start of session committee, chairman John McFall asked Sikka: “Do we need to throw the auditors out or keep the auditors and bring other new people in? If everybody has done their job, why are we in this situation?”
“My feeling is that we need a fundamental change in accounting and auditing. If you look at bank reports and accounts, not a single bank has given us any figures at all about any company’s specific assets, liability, income, expenses, credit default exposure, derivative exposure. The information is simply not there at all.
“The auditors are too close to companies. They get their fees from the companies, therefore they cannot really bite the hand that feeds them.
“If the FSA were to liaise with auditors, that would create too many problems. The auditors claim confidentiality on their working papers and the FSA has basically been operating blind, assuming that the auditors would alert would anybody to any risks, any problems.
“Our system has really fallen apart and the underlying idea that commercialized accounting firms, as I put it bluntly, one bunch of commercial entrepreneurs, can somehow regulate another bunch of commercial entrepreneurs, that is company directors, that kind of model is broken, it cannot work.
“It has not worked because what we have seen in the current crisis is that within days of getting a clean bill of health from auditors, many banks have simply collapsed.
“We are often told that the market has taken note of audit reports. What we have seen here for the first time is markets saying, ‘We do not believe a word the auditors have told us because all the assets, liability, numbers are unbelievable.’ Audit reports have been totally discounted, financial statements have been totally ignored…”
Paul Boyle, outgoing chief executive of the Financial Reporting Council and Robert Hodgkinson, executive director at the Institute of Chartered Accountants in England & Wales, were unconvincing in their defence of the status quo. By contrast, to me at least, much of what Sikka said had the ring of truth to it. He also said:
“I am very sceptical of what the institutions (FRC and ICAEW) are saying. The FRC has been basically asleep on the job. Northern Rock was the warning, that did not result in FRC scrutinising banks’ accounts and so on …
“I do not recall the FRC taking any initiative to scrutinise bank accounts or anything else. We heard about ethical codes. The last ethical statement issued by the Auditing Practices Board was drafted by a committee consisting entirely of the ‘big four’ accounting firm representatives and nobody else. The whole thing is a charade ….”
“There is a real issue here about what exactly an audit is for. What we are hearing is that auditors might know that a bank has financial problems but they do not want to tell anybody …
“Auditors are paid a lot of money to make judgments and if they find something they have to tell, simple as that. There is no point in keeping quiet, that does not forewarn the regulators or the public, that is their duty. They are simply hiding behind the fact, I think, that they do not want to upset their clients.”
“My feeling is that accountancy firms are a barrier; they themselves are part of the problem in this particular function, and they really need to be removed from this role.
“This role has to be taken by the regulators – that was one of the original proposals when the SEC itself was being formed in the 1930s, recognition that you cannot get private business to regulate another private business.
“There is a related issue: I do not think the Big Four accounting firms are fit to conduct public watchdog functions. In my submission I have highlighted how they have been involved in running cartels, tax evasion, bribery, corruption, many other things; it is difficult to see how such entities can actually deliver the public interest function.”
He may have been referring to the fact that, in December 2008, Robert Pfaff, a former tax partner at KPMG, and John Larson, a former senior tax manager at the firm, were convicted on several counts for selling “Blips” (tax shelters) to wealthy Americans. Sentencing them to long prison terms of eight and ten years respectively, judge Lewis Kaplan said the two bean-counters had cooked up a “mass-produced scheme to cheat the government out of taxes for the purposes of enriching themselves.” Yet Kaplan dismissed charges against 13 other KPMG executives. KPMG was not a defendant in the trial, having earlier struck a deal with the US authorities.
Sikka went on to say that the International Accounting Standards Board (IASB) is a “creature” of the ‘big four’ accountancy firms and that “the FRC acts more as a cheerleader rather than a regulator for the big firms. It has really failed.”
Professor Michael Power, professor of accounting, at London School of Economics, conceded that, given the complexity of many bank products — such as collateralized debt obligations (CDOs) — the rear-view mirror approach taken by the profession is largely redundant. He said: “There is a bandwidth of states of the world, if I can call them that, where audit works very comfortably: that is to say it can rely on management representations, it can rely on management accounts, it is confident that management is on top of its own organisation, that is the world where auditors are able to do their job most comfortably and where the incremental assurance that society demands is provided. We are not in that world.”
Further to claims from Brendan Nelson, vice-chair of KPMG, that the accountancy firms are acting dynamically, that is, with at least some sort of awareness of what’s happening in wider financial markets, George Mudie MP retorted by saying: “I struggle with that because the consistent line up to now is you are not corrupt, you have not done this for these additional fees, you are not incompetent, you are doing it within strict lines and we the public and we the politicians just do not understand how limited your role is. Now you tell me that you are ‘dynamic’; how does that square with what is happening, because I asked the last panel what changes [have been made or are being made] and they [said they] have not got round to even thinking about it, discussing it, analysing it.”
Addressing Nelson, Mudie added: “Brendan, if you were watching this on television and you had lost your job, you were going to lose your house, you would be pretty bloody angry at the auditors for allowing the banks to get away with all the off-balance-sheet derivatives, the lot. As you go in and audit them the ordinary person would say “Why the hell didn’t the auditor pick it up?” In an intelligent discussion you are saying to me “Well, it is not our business.” Will it be your business in future or will there need to be discussions and changes, maybe even changes in the law? Have you started those?”
KPMG signed off the 2007 accounts of a surprisingly large number of disastrous banks and financial institutions around the world. In the UK, these included both HBOS, Kaupthing Singer & Friedlander, and Bradford & Bingley. KPMG also audited Countrywide (US), Hypo Real Estate (Germany), Independent Insurance (UK), Fannie Mae (US), Fortis (Belgium/Netherlands), New Century Financial (US) and Wachovia (US). It certainly makes one wonder about the rigour and dynamism of its audits. (See my earlier blog post titled: Time to audit the auditors).
Before the select committee moved on to the equally culpable credit rating agencies, Jim Cousins MP, asked the bean-counters: “In the end, therefore, we rely not on you, not on the audit process, but on the competence and capacity of boards of directors of banks who plainly have already failed us. That is your view?” If this is right what is the point of PLCs spending millions of pounds to have their books audited at all?”
That is a very good question Mr Cousins.