After a String of Corporate Scandals & Collapses, “Big Four” Accounting Giants Face Breakup in the UK

UK regulators may be on the verge of doing something right, but doubts remain over how genuine their stated intentions are.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

Following a string of corporate scandals and collapses, the UK’s top accounting regulator, the Financial Reporting Council (FRC), has called for an inquiry to explore the possibility of breaking the audit arms of the Big Four accounting firms — KPMG, Deloitte, Ernst & Young, and Price WaterhouseCoopers — into separate pieces. The Competition and Markets Authority (CMA) should look into the possibility of “audit only” firms in a bid to enhance competition in the sector, said FRC chief executive Stephen Haddrill.

There’s a strong case to be made for taking such drastic action. Having extended their tentacles into just about every facet of business administration, from accountancy and auditing to legal and tax consultancy, while wiping out or gobbling up many of their smaller rivals, the Big Four firms have grown horrendously large and conflicted.

Time and again they have signed off on accounts that were demonstrably faulty and allowed the management of large companies all over the world, such as the UK’s Carillion, Spain’s Abengoa, Japan’s Olympus, and the UK’s two biggest banking failures, HBOS and RBS, to mask the true state of their financial health. In the case of Spain’s Abengoa, its auditor, Deloitte, was seemingly unable to detect blatant flaws in the company’s accounting that were flagged up a year earlier by a 17-year old student with only “basic secondary school knowledge of economics.”

Despite such embarrassing failures, the Big Four firms continue to cement their domination of the global auditing industry. In the UK, they audit 99 of the FTSE 100 companies and 97% of the FTSE 350, up from 95% five years ago, despite EU and UK reforms ostensibly aimed at tackling a lack of competition in the sector.

It’s a pattern that is replicated throughout advanced economies. In the US the Big Four audit 497 of the 500 S&P 500 companies. In the vast majority of EU Member States the combined market share of the Big Four audit firms for listed companies exceeds 90%. Their global annual revenues reached $134 billion in 2017.

In the UK even the fifth biggest accountancy firm, Grant Thornton, has decided to stop bidding for audit contracts from big companies after repeatedly coming second to the Big Four. The firm has put in tenders for a number of FTSE 350 audits but only won two since mandatory 10-year audit rotation came into force in June 2016. Since an audit pitch can cost up to £300,000, Grant Thornton has decided to move away from tendering for FTSE 350 audit work, at least until there is a “shift in the competitive landscape that would level the playing field.”

The problem is not just the size of the Big Four firms but also the colossal conflicts of interest they create by having their fingers in so many different pies. A case in point: when Spanish authorities tried to roll seven failed or failing Spanish saving banks into Bankia in late 2010, Deloitte was hired not just as Bankia’s auditor but also the consultant responsible for formulating its accounts, in complete contravention of the basic concept of auditor independence. In 2012, not long after its IPO, Bankia collapsed and was partially nationalized to bail it out.

There’s also a clear agency problem stemming from the fact that auditors (the agents) are appointed to companies and paid for their services by the managements they audit (the principals). This mechanism creates an inherent conflict of interest for auditors. In a recent FT article featuring reader suggestions on how to improve auditing practices one reader, Owen Wilson, proposed that audit firms should be engaged on behalf of the stock exchange rather then the companies listed on it.

Another FT reader, Robert Hodgkinson of the Institute of Chartered Accountants in England and Wales, argued that splitting up the Big Four would be easier said than done given they operate in the UK as part of huge global networks: “Splitting the firms in the UK would achieve little except making Britain a peculiarity — and the UK arms would have to ally with global networks to undertake multinational audits.”

This echoes my observation a few months ago: Due to their sheer size, influence and global reach, the Big Four are not just woefully compromised and conflicted, they may already have grown “too big to replace.” But that doesn’t mean it’s not worth trying to cut them down to size.

The UK may be on the verge of doing just that, though doubts remain over how genuine the regulator’s stated intentions are. The FRC itself has shouldered much of the blame for the Carillion collapse and even faces its own government inquiry following accusations of being too soft on big accountancy firms — no surprise given it is colonized by said firms.

Yet while the UK government and regulators may be excessively beholden to financial interests in the City, every now and then meaningful reform does occasionally slip through — normally when public opinion is close to breaking point. For example, thanks to the Vickers Rule, passed in the wake of the financial crisis, by Jan 1, 2019 all major UK banks must ring fence their core banking business from their investment banking operations — a measure authorities in the EU refuse to even contemplate.

If, on the off chance, something similar were to occur here, resulting in much needed root-and-branch reform of the UK’s audit industry, then perhaps something positive may finally come from the recent corporate scandals and collapses. By Don Quijones.

The London property market is already in trouble. Read…  UK Vows to Crack Down on Money Laundering: What Will This Do to the Property Bubble?

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.

 

  19 comments for “After a String of Corporate Scandals & Collapses, “Big Four” Accounting Giants Face Breakup in the UK

  1. cdr
    Apr 9, 2018 at 1:19 pm

    The UK concerns are a red herring. They’re probably a distraction so the public appears protected by govt officials.

    Auditors follow standards. The standards are not arbitrary. Auditors could not offer an opinion if they didn’t follow all applicable standards unless they explained clearly why a particular standard could not be followed.

    Auditors offer an opinion on the financial statements prepared by management. Auditors do not prepare the statements. If they did, they would be auditing their own work, which is a violation of standards. Most people don’t know this or choose to forget it when a good debate comes along.

    Auditors do not guaranty anything. The public wrongly assumes auditors are there to oversee management, look into every nook and cranny, and tell them what to do and how to do it. Or that they’re supposed to guaranty no fraud occurred.

    No issues with changing the standards. But accounting firms could and would be sued, successfully, if they chose to not follow them.

    Regulators blaming auditors is more likely to be regulators supporting their patrons via distraction.

    • Apr 9, 2018 at 2:34 pm

      You’re correct in that they don’t “guarantee” anything, but they have to render an “opinion” to the Board of Directors (included in the Annual Report) about the qualify of the financial controls that would lead to accurate financial reporting, and a ton of other things. They have a significant responsibility to investors. And when they fail, they can be held liable for malpractice. As in Enron.

      Here’s the latest example in the US, where the FDIC is going after PwC over a bank audit that revealed no weaknesses, and then a little while later the bank collapsed: “PwC faces largest ever auditor malpractice damages verdict”

      https://www.marketwatch.com/story/pwc-faces-largest-ever-auditor-malpractice-damages-verdict-2018-04-05

      • cdr
        Apr 9, 2018 at 3:02 pm

        1) didn’t read marketwatch because most business reporters are majorly incompetent when it comes to the details that tell the real story. If that one isn’t, it’s a rare exception.

        2) One example doesn’t say much. Unless actual fraud can be proven from the specific actions of individual auditors, such as Enron, this example will be broken down by lawyers as a slam against the standards. Juries don’t care about standards that have legal significance. If it’s too complicated they shut down and go with who has the best hair and is most likable.

        3) No argument against changing standards. Just don’t blame those who would lose everything if they decided to go populist rather than follow the legal demands of their occupation.

      • Apr 10, 2018 at 8:58 am

        Here’s a list of other lawsuits from the FDIC, yeah it’s a thing

        https://www.fdic.gov/bank/individual/failed/pls/

        • cdr
          Apr 10, 2018 at 1:57 pm

          I took a look at the list. The FDIC sued everyone and everything as individuals. No auditor conflagration. In fact, I didn’t see any accounting firms listed, although 1 or 2 might be in that long list somewhere.

          Look, if Joe the outside auditor covered up illegal loans to managers that were written off, that’s not an auditor problem. That’s crooks and collusion where one of the crooks happened to be an outside auditor.

  2. Steve clayton
    Apr 9, 2018 at 1:33 pm

    Hi DQ, hope ur well. The Vickers rule is a good idea if it stops bank bailouts going forward. I would love to see Deutsche Bank being made to split their bank up.

  3. cdr
    Apr 9, 2018 at 1:36 pm

    Re Carillion and others:

    Hypothetically, the company reported on could be a steaming flaming pile of human waste … as long as the financial statements accurately reflect the state of the company, including the notes to the financial statements, then it’s the investor’s problem for being financially illiterate. (Hence the popularity of non-gaap.) Not the auditor’s for offering an opinion that followed standards. The auditor would be sued, successfully, for saying ‘this company is a steaming pile …”, even if it clearly was. The auditor is there only to report on the accuracy financial statements.

    The only exception would be if a going concern paragraph were omitted when it should have been included.

    As I said, if you don’t like it, tell the regulators to change the standards.

  4. Apr 9, 2018 at 1:36 pm

    Accountants make the rules. This why some suggest the Taylor rule be made universal for corporations. In the wild west the best way to catch a cattle rustler was to promise to hang one, and turn him into the sheriff. You bust a few accountants and put them in charge as regulators. Problem at present is a revolving door between business and government, the thieves come and go as they please.

    • cdr
      Apr 9, 2018 at 1:43 pm

      “Accountants make the rules.”

      Yeah Yeah Yeah! Crooks love people like you looking in the wrong places at the wrong people and blaming the people who have to do things in a particular way unless they want to loose their livelihood. Crooks love it when people like you hyperventilate in the wrong direction using faulty information.

    • Scott
      Apr 9, 2018 at 2:23 pm

      I read an article a few years ago that argued one of the reasons that the accounting standards have become so complex and financial statements so long was the auditors and the accounting boards (which are largely controlled by them) wanted them complex as it would make it difficult for any new company to compete with them.

      • cdr
        Apr 9, 2018 at 2:41 pm

        Scott,

        Public and private companies follow somewhat different ‘auditing’ standards. Both follow similar ‘accounting’ standards. I lost track of the minutia that has changed in those sentences a few years ago. Among my other skills, I’m a licensed CPA who does not practice.

        Accounting standards are where the fun is. Mark to market debates from a decade ago are a good example. Banks could have evaporated back then from some ideas on that topic.

        It’s really a mix. Most is for the protection of the public. Things are complex because the world is complex and the ignorant need not apply. Some is for protection of vested interests. The definition of ‘vested interests’ is quite wide.

      • ML
        Apr 10, 2018 at 1:09 am

        Similar to the notion that the law was created by lawyers so as to provide a source of revenue. Viewed in that light it all begins to make sense.

  5. Quadra
    Apr 9, 2018 at 3:22 pm

    Its about time that someone raises the question.
    Why do more or less all have to use the big four?
    Basically if you don’t, you will directly have to answer the question why not?
    That needs to change one way or another.
    I have a meeting with one of the four tomorrow to sign of the yearly accounts. So I’m well acquainted how this work.
    I like the idea to split audit up from all other issue, that would avoid frequent conflicts of interest.
    Lets not mention the fees that a business have to pay today. Just to get and opinion that the books are correct. Usually we have to explain to the junior auditors how it works and then we have to face the bill since “it was more complicated then what we anticipated”
    Not convinced that this whole process adds value to end consumers.

  6. Petunia
    Apr 9, 2018 at 3:51 pm

    The biggest problem with the auditing firms is that they also do management consulting. When they find a problem, they use it to market a management solution to the firm. Then you get double the staff, billing the firm, and they provide the method of “fixing” the problem.

    It’s a variation on the scam that certain hedge funds use to target their victims. First they provide management consulting, then they use the information to raid the firm.

  7. raxadian
    Apr 9, 2018 at 10:56 pm

    If the public wants blood then these Big Four firms will get all the weight of the law, if the public gets distracted by shinnies nothing with happen.

    THE POWER IS YOURS! ( If you live in the Uk).

  8. MASTER OF UNIVERSE
    Apr 10, 2018 at 10:41 am

    I’m all for busting up the BIG four accounting firms into thousands of infinitesimally small pieces just like John F. Kennedy suggested with the CIA pre-assassination in 1963.

    KPMG is solely responsible for the bankruptcy of Iceland in 2008. KPMG
    is an international criminal network of unethical accounting auditors that have conspired to destroy sound money & honest price discovery. They are unprofessional, and wholeheartedly untrustworthy as auditors in business.

    Lastly, they don’t need to be broken up due to the fact that they will all topple as soon as Deutsche Bank or Citi implodes. Frankly, this year will evidence the demise of GE, Deutsche, Citi, & Wells Fargo. Once one of these banks topples we will see the auditing firms fully crash out.

    KPMG is most assuredly the worst criminal accounting firm the world has ever seen.

    MOU

    • George McDuffee
      Apr 10, 2018 at 3:29 pm

      KPMG is an international criminal network of unethical accounting auditors that have conspired to destroy sound money & honest price discovery.

      While the end result is the same, I think you are overstating the case. The Milgram experiment provides insight into how organizational culture warps individual moral/ethical values. FWIW: Organizational culture is almost impossible to change. The individuals involved are not necessarily unethical, indeed most are not, but are simply doing things the way they are done here.

      It is long past time that these accounting/consultant behemoths were broken up. Organizations this large, and larger, e. g. the banks and the US military, are beyond human control.

      • MASTER OF UNIVERSE
        Apr 10, 2018 at 8:25 pm

        I’m well versed with Chartered Accountants as I was raised by a CA, and I am well versed in terms of the Stanley Milgram Experiments due to my B.A. Honours in Experimental Psychology. In brief, deindividuation into ingroup or outgroup norms is not sufficient plausible deniability for moi.

        Accounting firms must be beyond reproach, and so too must Chartered Accountants. Finance degrees are there for a reason.

        MOU

  9. a.hall
    Apr 11, 2018 at 10:42 pm

    Any Accountancy Firm who sign off the Books of a Company, which promptly goes Bankrupt should be charged with Abetting Fraud; before and after the fact.

Comments are closed.