International Finance
Finance July-August 2019 Magazine

Audit sharing with tier 2 firms: A solution for Big 4 corruption?

Global calls for reform get louder as political and business leaders fear that a crisis of confidence in the accounting industry could hurt global capitalism

No other profession the world has seen its reputation being tarnished due to the ethical violations of its practitioners over the last two decades like the auditing profession. With the bankruptcy filing of Carillion in the UK in mid-2018, a discussion is raging in the country with regard to whether too few auditors are auditing too many companies in the UK. Global capitalism is lurching from one Big 4 audit scandal to another.

A House of Commons committee appointed to study the Carillion saga came up with the finding that Carillion’s accounts were systematically cooked to present optimistic assessments of revenue while completely discarding internal controls. An audit company, which was Carillion’s auditor for close to two decades and was paid £29 million for its services, did not once qualify its auditing opinion of the company and simply signed off the outlandish figures presented by the directors. Yet another firm paid £10 million by Carillion for its internal audit services, failed not only in risk management but also in financial controls.

KPMG South Africa in a soup

While UK’s parliament came down hard upon Carillion’s auditors, in South Africa, Big 4 audit firm was caught in a disturbing scandal. KPMG suffered collateral brand damage after it became known that the company had allegedly abetted the once powerful Indian-origin Gupta family in their shenanigans in the state capture issue. The firm was accused of helping the Gupta family, once called South Africa’s shadow government, evade taxes and indulge in corruption. Although KPMG denies any willful abetment of crime, it admitted to missing several red flags with regard to the family’s accounts. Eight senior KPMG South Africa officials were forced to resign including its CEO Trevor Hoole.

Testifying to the truly global nature of the ethical decision-making challenges and Big 4 audit scandals is the fact that India is seeking to ban Deloitte Haskins Sells and a KPMG affiliate BSR and Associates for their audits of a unit of Indian company Infrastructure Leasing and Financial Services (IL&FS), which nearly collapsed under mismanagement and has been placed under government control.

According to Reuters, India’s Corporate Affairs Ministry informed a company law tribunal that the auditors ‘miserably failed’ to fulfil their audit duties for IL&FS Financial Services (IFIN). There was more bad news for KPMG from UK regulator Financial Reporting Council, which analysed KPMG’ s audits and reported that they were substandard. According to Bloomberg, the regulator said auditors at KPMG do not challenge management enough, are not sufficiently skeptical, and are inconsistent in their execution of audits.

Fence eating the crop?

It is clear that as far as global capitalism is concerned, the fence is eating the crop. How do investors ensure that their money is in safe hands if the gatekeepers of capitalism are abetting corporate malfeasance willfully or by implication? The UK FRC report has drawn sharp reactions for the reform of the industry including calls to dismantle the Big 4. The Parliament committee in the UK believes that the wider economy risks a crisis of confidence in the audit profession as Carillion was not an isolated failure.

The committee said that the failure was the symptom of a of a market that works for the audit firms but fails the wider economy with umpteen conflicts of interests. The committee’s final report recommended that the British government should refer the statutory audit market to the Competition and Markets Authority. The CMA review could consider the breakup of the Big 4 into more audit firms as well as severing off audit units from other professional services units. Not surprisingly, the auditors have opposed these terms and have instead suggested a system of joint audits or lending their staff to smaller firms, so that smaller firms could get a share of the work.

Following the collapse of Enron and Arthur Anderson, the US addressed the auditing fraud issue by implementing the Public Company Accounting Oversight Board (PCAOB) through the Sarbanes Oxley Act of 2002. The monitoring of auditors has greatly increased in the US since the creation of PCAOB. Audit committees in the US are also said to have improved their willingness and ability to monitor auditors.

Investors are eligible to ask for strong audit committees of the board and pay more attention to what audit committees do. The US is a nation of laws and there is strong law enforcement. What happens when auditors make mistakes in countries where the law is not as strictly enforced as the US? The issue of ethical violations at auditors is no way restricted to the Big 4, but the Big 4 are symptomatic of the wider industry. If ethical decision-making falls by the wayside at Big 4 auditors, how do smaller independent audit organisations stop succumbing to the pressure to retain clients at any cost?

Smaller firms and pressure

“The question in 2001 was ‘If Arthur Andersen, one of the largest and apparently most technically proficient practices was brought down because of malpractices, why can’t this happen to smaller firms? They are under greater pressure from the sheer power of larger corporate clients,” Wesley Montechari Figueira, managing director at VBR Brasil Group, an independent accounting firm in Brazil told International Finance. VBR has clients in manufacturing, retail, and energy and around 30 percent of its gross revenue comes from international clients operating in over 25 countries. Accounting scandals are not new in Brazil, neither are scandals involving the Big 4 audit firms.

The Latin American country’s former president Dilma Roussef was impeached for apparently cooking the books of her country’s accounts. In December 2015, the American auditing watchdog PCAOB fined Big 4 leader Deloitte’s Brazilian unit $8 million for the most serious misconduct uncovered by the body till then. A probe into Deloitte’s audit of Gol, a troubled Brazilian airline with shares listed on the NYSE, found that Deloitte’s employees in Brazil, including managers and partners, had doctored paperwork, concealed evidence, and withheld information from inspectors. Similar incidents were again recorded in Deloitte’s audits of Oi a Brazilian telecom company that filed for bankruptcy in 2016.

Figueira is of the opinion that internal regulations and technology are of limited help in tackling the issue. “As in other professions, technology is replacing personal contact and while internal regulations can help govern ethical decision-making, they are not the only solution. Ongoing staff training, monitoring, and evaluation must complement regulations.”

“What we have learnt from past malpractices in accounting is that Brazilian accountants must end their willingness to ‘accommodate’ dicey situations rather than confront them. This must stop. Brazilians tend to like a ‘friendly’ auditor. The small and often non-existent fines imposed by our SEC, association of accountants or other governing bodies, speaks volumes about the battle we still have with ethics,” adds Figueira. Deloitte Brazil then faced the ignominious situation of an independent monitor overseeing its work till mid-2017.

At that time the PCAOB had just fined Deloitte Mexico $750,000 for tampering with documents in an audit done in the central American country. Operating out of Mexico, the team at independent auditor JA Del Rio claims that it has created a culture of learning from others mistakes. “We deliver an ‘unusual operations’ report every month to the relevant authorities, in compliance with our ‘prevention and identification of operations with resources of illegal origin’ policies.

“Our internal risk team keeps track of our clients’ business behaviour and their activities through risk matrices while our compliance officer identifies and evaluates risks associated with bad practices, integrating compliance and anti-bribery guidelines within our policies and processes, Bernardo Del Rio, managing director at JA Del Rio told International Finance. With headquarters in Guadalajara and offices in Mexico City, Leon, Monterrey and Bogota, Colombia, JA Del Río is a multilingual accounting firm focused on helping foreign companies do business in Latin America.

Carlos Mercero, a managing partner at Shilton, Weyers & Associates, an Argentinian company that provides audit, tax, consulting and advisory services to over 250 local and international clients from a variety of sectors, told International Finance that while encountering issues, both in the audit and in tax returns, Shilton, Weyers, and Associates, always takes the technical viewpoint. “Our work and effort to detect client fraud focuses on the key point that all managers, at all times, face the same risk and the temptations of bad behavior. And this is perhaps the main lesson we should never forget; that the risk of fraud never disappears,” he adds.

Never done before

In 2014, The head of the South African Revenue Service hired KPMG South Africa to conduct a forensic investigation into an intelligence unit of the national revenue service as well as four officers in the unit. KPMG SA’s report went on to suggest that the unit was using illegal methods and was therefore ‘rogue’ in nature. The report became a major embarrassment for KPMG as it came to be known that an auditor at the company had simply ‘copy-pasted’ the report from elsewhere. A commission appointed by the South African Institute of Chartered Accountants (SAICA) to probe the affair concluded that when a person cuts and pastes a report, it is not only dishonest but unethical.

After a KPMG international investigation into the South African unit, KPMG simply retracted parts of its report into the rogue unit probe – something absolutely rare in the world of auditing. Elsewhere in Africa, Egyptian Independent accounting firm Mazars Mostafa Shawki’s managing partner Dr Ahmed Shawki who keeps an eye on the African audit scenario told International Finance, “It is very dangerous for any accounting firm to mix politics and professionalism, and inconceivable that a big company can conduct a forensic audit, issue a report, and later withdraw it, as KPMG did in South Africa.” Mazars Mostafa Shawki serves over 1000 clients from two offices in Cairo and Alexandria, has 25 partners and employs 468 professionals.

“One of the key learnings from the KMPG South African scandal is that every firm should have a centralised system for client acceptance and engagement. The completion of a standard form ensures due diligence is undertaken prior to the provision of professional services,” adds Shawki. “Those completing the client acceptance forms should be a centrally-located team of risk management professionals.”

In the context of the accounting scandals in the emerging markets and South Africa,”  Mazars South Africa partner Kariem Hoosain recommends that auditors should pay special attention to politically-connected clients and understand the relationships of employees charged with governance and key executive and management staff. “It’s also vital to exercise genuine professional sceptism, particularly where you have a dominant chairman, CEO, or other key executives in the client, and apply rigorous and consistent quality assurance policies and procedures, irrespective of the so-called ‘great reputation’ of the client. Audit partners and managers should not become complacent.”

Hoosain added that partners and managers should go that extra mile to perform additional work where higher risk has been assessed, and not be constrained by budgets. “Partners should have open and frank discussions with those charged with governance, where fee estimates are inappropriate to the risk profile of the client,” says Hoosain.

Coming back to the FRC UK review of KPMG’s audits, the regulator reported that the decline in quality over the last five years was unacceptable and reflected poorly on efforts by the previous leadership to improve the work. “This is further evidence that problems at KPMG are profoundly systemic,” Atul Shah, a professor of accounting and finance at the University of Suffolk had then told Bloomberg. “They are a profit-maximising business rather than a professional firm with standards of independence, character and integrity. To reform the Big Four, we must address these cultural problems and conflicts of interest.”

Is rotation a solution?

How do governments in the UK and in the emerging markets confront the looming crisis of confidence in the auditing companies and their audits? It is evident that the monopoly of the Big 4 has to be broken to increase the pool of auditors and opportunities must be created for gradually increasing the mid-tier auditors’ share of the top audits. In most markets including the emerging markets such as India, the Big 4 auditing firms invariably audit virtually all of the major companies and corner the most important audits.

India had instituted a system of rotation of auditors through its Companies Act 2013. However, observers believe that this has not helped the smaller firms lay their hands on the major audit pie, because most of the major audits are rotated within the Big 4. The fact is that there is ample circulation of the same staff within the Big 4 audit companies ensuring that their culture remains the same. The aim of the Indian Companies Act is thus largely defeated. The issue of rotation is also being actively discussed in the UK.

In Africa, currently there is no clear move to limit the number of audits the Big 4 do or to rotate the auditors. In Egypt, the Financial Regulatory Authority is implementing rotation for public-listed companies every six years. In addition to the Big 4, three other big firms – BDO, Grant Thornton and Mazars – play a big role in the Egyptian audit market. Mazars Mostafa Shawki’s Ahmedi Shawki says that perhaps the implementation of a joint auditor concept is a solution.

On the other hand, Mazars South Africa Partner Kariem Hoosain suggests a solution similar to the one suggested by the UK Big 4 in response to the parliament committee hearing. “There are some practical challenges associated with a rotation strategy. ‘Smaller’ companies may not have sufficient capacity and expertise to take on the work that the Big 4 would need to shed. A better approach would be to “phase-in” mid-tier firms through graduated joint audit assignments. There doesn’t seem to a global push to do so, although it is under consideration in the UK.”  

In Latin America, smaller audit companies seem to be diffident that such an arrangement can be worked out in the region. And there is no desire to create pressure on the auditors as seen in the UK or Africa. Mazars Uruguay partner Luis Martinez argues “In many cases, there’s a problem of size and capacity; only these very large firms can do the work. However I do concede, joint audit and rotation may help spread the workload across the market.” Mazars is an international audit, accounting, tax and advisory services organisation with more than 23,000 professionals operating in 89 countries. In the region it is rare for smaller audit firms to audit larger companies, although some do audit such companies, especially those not listed on the stock exchanges.

Mexican company JA Del Rio Managing Partner, Bernardo Del Rio says “I think it could help, especially if national regulators required rotation. This could in effect open up the field for smaller firms as these subsidiaries individually could never compete with the head office of a large player in a specific country.”

VBR Brasil Group’s Figueira sees pros and cons in an approach that uses a single firm to undertake an audit and one that uses other firms and organisations’ resources. “When one larger firm is involved, there’s a single methodology which makes things faster and the cost to the client is likely to be smaller. And while there’s always an element of pressure, there’s no significant pressure from external third-parties on the audit department. However, with a single firm it’s easier to ignore or hide country-specific problems, individual teams are less accountable and less-experienced professionals may be used.”

According to him, a multi-firm approach tends to give greater independence to auditors. Equal partners in different locations can discuss problems and not allow themselves to be overruled by the larger client nor the ‘larger partner’ somewhere. This also reduces the pressure that a single firm is subject to during fee negotiation and the impact any negative feedback may have, since the opinions are formed within an audit department elsewhere.

“Differing methodologies and processes can be a benefit, leading to a more in-depth analysis of a problem and clearer conclusions – the ‘clash’ between different views and methods can be a plus. More senior staff are likely to be used as the command chain is shorter.” With regard to the cons he adds,” But, differing methodologies can for sure, slow things down, it may be difficult to agree and approve costs or measure the quality and quantity of work undertaken.”

Big 4 audit firm break up

Angus Dent is a leading UK chartered accountant and former CFO and CEO of AIM- and TSX-listed technology businesses as well as the founder of UK business P2P lending fintech startup ArchOver. With regard to the UK, Dent told International Finance that the break up of the Big 4 as the political leaders want is easier said than done. “We need to break the oligopoly that is the Big 4, although that’s easy to write and hard to enact. Companies need more choice. Only with choice is there competition and the audit service that the paying companies and users of the accounts need,” says Angus. Companies are complex, so auditing is therefore complex as well.

The big four have large technical departments, which is a big overhead and a barrier to entry for smaller firms. “Perhaps we could see the two chartered institutes, ICAEW and ACCA, build a technical service to rival those of the Big Four. The ICAEW already provides a service to members, but currently it is not as well-resourced as a single one of the Big Four’s technical departments,” adds Angus.

A shared technical service is one idea put forth as a solution to help smaller firms to gain a share of the top audits. “The existence of a shared technical department providing services to smaller firms could be very useful. This would overcome the main obstacle for smaller firms which is to have an efficient and strong enough structure to provide services to all types of clients, regardless of the size of the company,” says Shilton, Weyers & Associates Carlos Mercero. In Latin America, Mazars Uruguay partner, Luis Martinez is open to the idea “Technical departments need to be good, not large. And when a firm is global – and there are many global firms beside the Big 4 – resources can be shared, as in the case of Mazars. I like the idea of national bodies having technical departments to help smaller firms.” 

However, Mazars South Africa Partner Hoosain is sceptical about the idea. “Technical assistance by way of shared-pooled resources can only have a very limited impact. The main issues to consider is a lack of specific industry experience, understanding the client and its operations, key risk drivers, group structures, related parties and so on and key audit team members’ independence from the client. There would also be other practical challenges such as investment, cost sharing and prioritising requests from firms at ‘crunch’ times when reporting deadlines have to be met,” says Hoosain.

Let reform start from London

So what reform can governments and audit professional bodies consider that are within the realm of possibility. In the UK, Angus Dent is of the opinion that limiting the number of audits of FTSE 350 companies that the Big 4 will help.

“A simple start would be to say that the Big Four could only have a maximum of around sixty audits each of the FTSE 350 companies – that would spread things around and force some of the smaller FTSE 350 companies to seek the services of other audit firms. Two years later, the number of these audits that can be conducted by the Big Four could be dropped to forty each and so on.”

 According to Angus, this would force more effective competition and give the bottom half of the top ten an incentive to invest in technical departments, or club together and put more money in to the ICAEW, knowing that they would get more work than they are currently able to snag. At present they don’t invest in audit services for larger companies because they see little or no return on it as a result of the Big Four’s oligopoly. Considering the global reach of the accounting scandals, Angus Dent believes that auditing reform started from the UK would have global impact. Start in London and let the UK be the standard bearer for global reform. London is already a world centre for finance; let’s make it the world centre for quality audit, audits that can be relied upon. If that happens, the rest of the world will follow,” concludes Angus.

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