Time to reform the Big 4

The U.K’s largest accounting firms, colloquially known as the big 4, and others have been criticized by the Financial Reporting Council (Britain's accounting watchdog) for their ‘unacceptable’ decline in quality after a third of their audits fell below expected standards. The FRC report reserved much of its criticism for PwC, KPMG and Grant Thornton mainly for their involvement in the infamous business failures including WireCard, Thomas Cook, Carillion & Patisserie Valerie. It found that 35 per cent of PwC’s audits and 39 per cent of KPMG’s audits required improvements. So what are the reasons behind their  shortcomings?

One reason presented by the FRC was the existence of conflict of interest within firms due to the firms having wider practices closely integrated within the audit practice and consistent cross subsidisation into the audit division. To counter this problem the FRC have asked the big four to separate their audit practices from their consulting, restructuring and tax operations by 2024, with the expectation to eliminate conflict of interest issues. Another potential reason posed was the observation that many accounting firms were not ‘standing up’ to their clients management, meaning, auditors were failing to challenge companies, particularly on issues such as revenue, contracts and investment property valuations. The FRC have prompted the accounting firms’ senior management to create a more open culture of taking difficult decisions and inducing stricter client management while asking for information.

Although the FRC believes separating the audit division from wider company practices may shift the tide and improve audit quality many others are sceptical. Many believe that crucial innovations in the accounting sector, such as AI, block chain and robotics, can only be achieved through scale and financial strength, something that cannot be obtained by removing them from their parent company. They argue that it is these advancements in the sector that will inevitably boost audit quality and performance and so it is integral to keep the divisions together. That being said, time will only tell if the FRC’s decision will lead to the improvements required for this consistently sub-standard sector.

Another example from the US- Lehman Brothers. Despite an audit the auditors failed to detect a potential collapse. The reports didn’t make accurate long-term projections after considering market uncertainties and risks. Lehman's commitment to subprime loans was a result of their expectations that market boom in the housing sector would sustain. Instead, the faulty audit reports rendered them incapable of implementing counter strategies when the market fluctuated. Their audit reports should have revealed the excessive borrowing that raised their leverage ratio above what is prescribed. The firms, however, window dressed its financial statements to deceive its stakeholders. The auditors, Ernst &Young, on being questioned, claimed that they only agreed to the accounting treatment applied to the transactions, but didn't actually look at the transactions themselves, their overall impact on the financial statements, and the real reason why they were used.

India's biggest corporate fraud, 'Satyam scandal', one of the biggest scams, misled the market and other stakeholders by lying about the company’s financial health. Even the basic facts such as revenues, operating profits, interest liabilities and cash balances were grossly inflated to show the company in good health.

SEBI’s investigation found that Price Water Coopers did not independently verify bank statements and fixed deposit receipts nor disclose the lack of such verification in the audit report. PWC argued that it had undertaken verification and that the fixed deposit receipts appeared to be genuine. The regulator found that not once in eight and half years did PWC request independent confirmation from the New York branch of Bank of Baroda and instead relied on Satyam to source the confirmations from the bank.

Another error found was, though Satyam was predominantly a services company, several of the fake bills related to products and that should have alerted the audit firm. Another revelation was that the company reported fictitious sales thereby making space for fictitious debtors. Despite PWC's contentions that the standards of duty of an auditor are different from that of the firm and that all partners cannot be held liable for the actions of two, SEBI has penalised all 11 accounting firms operating under the PWC brand in India.

In all the above cases, fraud while auditing has been considered a common problem.  Auditors simply signing off on a theoretical accounting treatment, and not examining any of the transactions or their materiality doesn't seem to meet the professional standards. Auditors must have sufficient, competent evidence to support their opinions.

Written by- Meghna Raj Saxena