The “oligarchy” controls the standard-setters, ensuring rules of the game suit it. The long reach of the bean counters also extends deep into the heart of government.
By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.
KPMG, one of the world’s “Big Four” accounting firms, has shown an “unacceptable deterioration” in auditing British firms and will be subject to closer supervision, the UK’s top accounting watchdog warned on Monday. “Fifty percent of KPMG’s FTSE 350 audits required more than just limited improvements, compared to 35% in the previous year,” the Financial Reporting Council (FRC) said.
In other words, KPMG’s UK auditing division got about half its work in the last year badly wrong and is about to have its auditing work more closely audited. The increased scrutiny of KPMG will involve the FRC inspecting 25% more audits done by the firm in the 2018-19 financial year, the first time the FRC has taken such action.
KPMG is under the spotlight in large part due to its abject failure to properly audit the UK outsourcing giant Carillion, which collapsed at the beginning of this year. Between 2012 and 2016, Carillion ran up debts and sold assets just to continue paying out dividends to shareholders. Yet in Carillion’s last ever annual report, KPMG approved Carillion’s viability statement, certifying it as strong enough to survive for “at least three more years.” Within less than three months, Carillion was bankrupt.
The biggest asset on Carillion’s books was £1.57 billion of “goodwill” — an intangible asset that arises when one company purchases another for a premium value. It does not include physical assets like buildings or equipment, of which Carillion, as an outsourcer, had almost none. Instead it is supposed to encapsulate the additional value provided by intangibles like a company’s brand name, solid customer base, good customer relations, and any patents, or proprietary technology.
Thanks to the unending M&A boom and recent accounting changes, this “hope” value has become a significant part of corporate balance sheets. During recent grilling by two select committees Stephen Haddrill, chief executive of the Financial Reporting Council (FRC), said that while it was “not good practice” to have so much goodwill on the balance sheet, it was “not untypical.”
Since 2005, companies have been able to treat goodwill as a permanent asset, only writing it down if it is deemed “impaired” by the company and its auditors. But impairment tests are decidedly subjective and their outcome largely depends on the honesty of a firm’s management and its auditors, a somewhat dicey proposition.
On KPMG’s watch, Carillion was able to attribute £329 million of goodwill every year for seven years to a public contractor it acquired in 2011, despite the fact the company had become “virtually worthless” not long after its acquisition. By 2016, the subsidiary’s revenues had shrunk to just £43 million (that’s down 95% from its pre-takeover level), and it had run up cumulative losses of an astonishing £350 million under Carillion’s ownership. Yet it was still generating £329 million worth of assets on Carillion’s annual balance sheet.
KPMG seemingly had no issue with that, which raises further questions about its capacity to audit British companies. The Dutch-based auditor has already had a leading role in some of Britain’s biggest corporate disasters of recent years, including the highly controversial collapse of the high street lender HBOS, which was subsequently covered up by the FRC .
But it’s not just KPMG that’s under the spotlight. Following a string of high-profile corporate scandals the FRC has launched an inquiry to explore the possibility of breaking the audit arms of all Big Four accounting firms — KPMG, Deloitte, Ernst & Young, and Price WaterhouseCoopers — into separate pieces. Frank Field, who chairs the Work and Pensions Committee, said there was an “oligarchy” in the sector and asked whether the committee should recommend that the four firms be broken up.
An article in The Guardian aptly titled “The Financial Scandal No One Is Talking About” points out that alumni of the Big Four control the international and national standard-setters of the accounting industry, ensuring that the rules of the game suit the major accountancy firms and their clients. The long reach of the bean counters also extends deep into the heart of government:
In Britain, the big four’s consultants counsel ministers and officials on everything from healthcare to nuclear power. Although their advice is always labelled “independent,” it invariably suits a raft of corporate clients with direct interests in it. And, unsurprisingly, most of the consultants’ prescriptions – such as marketisation of public services – entail yet more demand for their services in the years ahead.
In the UK, the Big Four 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 vast majority of EU Member States the combined market share of the big four audit firms for listed companies exceeds 90%. But it’s in the consulting business where the real money is being made.
And real money is definitely being made. In 2017, the big four’s combined global annual revenues reached $134 billion. And the rate of their growth keeps expanding faster than the world they serve, as The Guardian reports:
In their oldest markets, the UK and US, the firms are growing at more than twice the rate of those countries’ economies. By 2016, across 150 countries, the big four employed 890,000 people, which was more than the five most valuable companies in the world combined.
Given the amount of wealth, power, influence, and control the big four have accumulated in recent decades, trying to bring them back down to a more manageable size is going to require a herculean effort. But at least it’s an idea that’s finally getting some attention. By Don Quijones.
The challenges of an industry dogged by non-believers who fret about privacy and fraud. Read… Consumers Stubbornly Cling to Cash, after Multiple IT Fiascos & Payment Systems Outages
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Gee…I could be wrong, but I think KPMG also “audits” the US Federal Reserve and says all is peachy. Hummm.
Didn’t they get a slap on the hand in 2008 as well?
I just told DQ as soon as I’d read the draft of his article that I’d catch a lot of crap over this. And sure enough, it only took a few minutes… :-]
For those readers who aren’t in on this, here’s my offending comment:
Yeah and its not why Ron Paul wants to audit the Fed. He wants to open the books all the way back to Nixon, and my feeling is that things are done at the Fed which the Fed chief does not know about and does not want to know. There some things no president wants to have done on a government issue computer, and the argument is the Fed independent, really comes down to the dual use policy.
You’re correct and I believe the “audits” are nothing more then a rubber-stamp affair involving a lot of glad-handing and taking of selfies with Fed heads to post on Facebook.
I got admonished a few days ago for stating that the Fed is not audited, technically they are audited , but I don’t believe they are given a true audit. I will be the first to admit that beliefs or feelings don’t count for anything, only the truth matters – I just wish the truth was not so difficult to unearth.
I don’t doubt that the Fed keeps a spreadsheet ledger of all their “balance sheet” transactions and I’m sure they make this balance sheet information open to an auditor. But I doubt the balance sheet represents all of their monetary “interventions” and I suspect the Fed has a second set of books.
I’m not interested in an audit that involves looking over their official set of books, I would like an audit that rips that place down to the brass tacks to see whether there is another set of books they’ve been hiding. If you sent in a team of auditors, led by David Stockmen, and he gave them a clean bill of health then I would shut up about it.
Don’t forget, Bernie Madoff also had great “courage to act”, it took balls to pull off such enormous fraud – so what exactly was Ben Bernanke referring to when he professed his own great courage.
Saying the Fed is audited is like saying that the gold in Fort Knox is audited. (The last real audit of Fed Reserve gold was done in the 1960’s….every subsequent audit is a PAPERWORK exercise only….in which the party with motive to maintain the fraud controls all access to the paperwork….which is to say lacking even the appearance of independence.)
There is a reason that the Pentagon can’t account for 1 TRILLION in spending over the past 15 years…..the gov’t can’t ACCOUNT for anything (other than the IRS) worth a hill of beans….and even the IRS typically gets whipped by a good accounting firm in court unless the taxpayer was an idiot.
Don’t worry guys, the Fed is in tip top condition!!!!
Data in the US is so much better than China. Heck it’s the bestest ever!!!
It should have been clear from the financial crisis that public auditors and the ratings agencies are totally worthless. Most of the biggest collapses have had sterling credit and financial statements right up till the very end. These functions need to be done by some agency that doesn’t rely on funding by competition. Until then the investors will not be protected.
“These functions need to be done by some agency that doesn’t rely on funding by competition. ”
When you say “funding by competition, do you mean
For example :
That KPMG neither sees nor hears any evil at a GE or Deutsche Bank audit because it fears it may lose the account to Deloitte if it did it’s audits with integrity ?
Yep, and see reply to peter.
About time these big firms, in whatever industry it is, got broken up so there is real competition again. And to have them “advising” governments is crazy; why not just put them in there and let them run the country? After all they pretty much do anyway. Would probably be more efficient as wouldn’t have all the advisors to pay.
Good article Wolf, keep blowing the lid on our society!
Competition is what corrupted them in the first place. When they have to compete on price there is a lot of pressure to give the client whatever they want. The other big corrupter is management/consulting services. Management consulting is a big money maker and a huge data miner for the firms. Most of the financial engineering in companies can be traced to these consulting services. Auditing has become something they throw in to get consulting contracts.
I don’t agree entirely with your thesis. If what you said is true, then it also applies to every human endeavor that competes on price and that’s basically 99%. Also I am sure you’ve heard of monopolies? Do we have to argue again on why those are bad.
If they all compete on price, then management consulting can’t be a huge money maker since everyone will also compete to lower the price on those?
No the biggest problem just like how it is with the rating agencies is that there’s an inherent conflict of interest in these relationships i.e. it’s like you directly paying the teacher to grade your kids.
Here are my suggestions:
1. Investors should be paying these companies. How? One way is through asset management companies.
2. There can not be under any circumstances a revolving door relationship between these firms and the firm they audit or rate and the government.
3. Partners need to be personally liable for audit mistakes i.e. no auditing companies can be public.
“1. Investors should be paying these companies. How? One way is through asset management companies.”
Asset management companies can take short positions and thus have incentives to see companies fail.
Auditors don’t just sell a service to a client. They are really selling a universal seal of approval, which is consumed by third parties who are not parties to the transaction, but are affected by it. Because the third parties, you and me, are the real consumers, we need protection from the two parties who have everything to gain from colluding for their own benefit.
@akiddy111, you do know that short positions can only give you a max of 100% right? Return in the asset market is assymetrical to the upside. In fact I would be more worried at the opposite, but the fact that asset management companies take both short and long position means that things should cancel out.
@Petunia, I understand. If you take a look at my proposal, that’s what I was trying to address. Asset management companies (i.e. funds) in theory are investing on our behalf. They should pay for the audit. It’s that old Reagan saying: “Trust, but verify.”
and you know what Nietzsche said about Darwin
Consulting is the business of walking into the room, determining who writes the check, and recommending what they want.
Auditors enjoy a somewhat similar relationship, but they do occasionally provide an unintended service to the public: if a company changes auditors, the notice of which is obligatory, experienced investors know to head for the exit.
When my little area of our company (the IT operations) was audited by AA, the auditors were young, untrained and had no idea what they were doing. Didn’t stop them from developing findings for my operation though. Sadly, I can’t think right now of an institution I respect – maybe Faithful Friends, the organization that finds homes for deserted cats.
The Accountant who gets the job is the one who answers the question “What is Two plus Two”?
With “Whatever you want it to be”!
It’s nothing new, the incompetence and corruption of the big 4 has been brought to light many times over the last few decades.
I’m going to go way out on a limb and say that none of these criminally negligent or complicit accounting firms, or any regulators or enforcers who turned a blind eye to the systemic frauds and deception on Wall Street, will ever face actual consequences in our crony capitalist wonderland.
Hey remember Greece? Why do people trusts in these kind of firms again?
He who pays the piper calls the tune. When buying a house you pay for the survey, not the seller.
Hi DQ, a lot of the banks have goodwill which makes Carillions amount look like chicken feed.
But goodwill doesn’t count in terms of “regulatory capital” — the capital cushion that is supposed to keep that bank from toppling when it starts losing money. Carillion’s problem was that it had no capital after goodwill was taken out.
Hi Wolf, but a banks goodwill is significant enough to change a story from profit to loss which investors would be looking at. One big euro bank has 8.8bn euros in goodwill as an asset on it’s balance sheet and a retained earnings figure of 18bn in their reserves figure, don’t think it’s bought anything significant since the financial crisis either.
Reading complaints about auditors is both a little funny and a little exasperating.
Auditors must follow standards, as the article states. The standards are supposed to protect the public. Assuming away outright fraud and incompetence, your definition of using standards to stop accounting fraud and improve accuracy will differ from that of others in places, and those places are where the controversy can erupt.
Also, some accounting is based on objectivity, such as 1+1=2. Some is based on estimates and assumptions, such as the useful life of an asset or is that debt collectible or when is that sale actually revenue. More fun here when setting standards. Bricks in boxes rather than actually inventory happen, but no wiggle room for differences of opinion make them less likely to actually be put into practice.
Finally, tax accounting is totally non-gaap and is not allowed to come near a public company financial statement.
Goodwill is a great example of goofiness. Someone paid too much for the business, The excess becomes goodwill and is an asset on the balance sheet. Impairment tests must be run.
I’ve personally never done one but I assume, like everything else in life, there’s some subjective evaluation involved and that’s where the shenanigans sneak in.
There’s lots of other places where the company might get creative and possibly buffalo the auditors: Asset valuation where ‘experts’ decide on the value because there’s no objective means, Revenue recognition where there are odd schemes involving a long time between the sale and the cash from it, and off balance sheet accounting https://www.investopedia.com/articles/investing/071513/understanding-offbalance-sheet-financing.asp.
While auditors are the best scapegoat for when things go wrong, the standards setting bodies are the main culprits because auditors would get sued and lose and go out of business if they went populist and wrote cowboy opinions and did not follow standards.
Also, the notes to financial statements, those thingies people like to ignore, are an integral part of the financial statements. Lots of stuff that can’t be quantified is written there. But … lets not forget the popularity of non-gaap numbers used to prop up the stock market. Which to you think the public actually prefers to use?
If you don’t like auditors, complain to the standards bodies. They will laugh at you but at least you tried.
Of course….there are times in which the accounting bodies recognize a major problem (mark to ‘fantasy’ assets prior to Enron) and move to correct bad practices (i.e. force companies to mark-to-market) but then politics (Obama’s corrupt Treasury Sec) overrides good accounting in order to ‘save’ the bankrupt money center banks which need to maintain the mark-to-‘fantasy’ accounting in order NOT to collapse (and need to be bailed out by taxpayers).
Nobody complains about a bad depreciation policy. Nobody cares. Less than nobody cares. Mark to market is more complicated when no references exist for valuation and ‘experts’ must be called in. Most assets valuations are as controversial as depreciation policy. Goodwill impairment tests are a potential job killer.
The big deals are assets with opaque values, revenues with unusual recognition policies, liabilities that are vaporous, and capital that is stated incorrectly as a result other issues on the financial statements.
Nobody defends fraud or incompetence, except the perps who want to get away with it.
I have no idea how things are done in the UK or the EU. I suspect similar to the US, just with more public officiousness over there.
The weak link is the populist view of what auditors should do. In short, auditors would be gone if they went populist and the crooks would do whatever they could convince the populists was a good idea. That’s a bad idea. Hence, standards and standards setting bodies. Financial statements would become a tool to sell stocks without the standards.
Now, how about some non-gaap stock hyping. Let’s make some money!
If you include 2 or more links (which you did), your comment automatically gets stopped until I release it. This is part of the anti-spam mechanism. Take it or leave it.
The name KPMG keeps coming up for as long as I can recall as horrible, there’s often something wrong if they’re involved with the audit!
The Enron saga and the participation of AA seems like yesterday.
If the Partner how signed the Opinion, as well as his Audit Manager on the audit, if they were held PERSONALLY liable for a bad audit, then most of the problems would be solved. Now, of course, you can’t sue an audit partner for millions of dollars, because he doesn’t have that kind of money. But you can take away his CPA permanently. That ends his livelihood. Suing the audit company itself, taking away their capital is senseless destruction.
I feel the audit company should be held liable for the actions of their employees and for that matter, contractors, temps, etc.
The problem with so-called auditing is in some ways similar to the problem with academia. In both cases the pressure is to bring in new business, so in auditing the real work is done by inexperienced and untrained junior staff while the senior staff spend their time at conferences and networking in an effort to generate business and raise their status in the firm. In academia what little teaching takes place is done by junior academics while more senior ones spend their time publishing pointless research and fishing for grants. Auditing is nothing more than a CYA tool – “hey, we were audited, what more could we have done?”.
Audited with a wink and a nod but little else. When a particular auditing firms name keeps coming up habitually under suspicious circumstances, it becomes obvious they’re catering to a certain (shady) clientele, should we say…
Similar to the shady salesman, stocks aren’t bought, they’re sold.
KPMG signed off on Iceland’s banking debacle back in 1999. KPMG should have been drummed out of town long ago.