Thursday, 8 June 2017

BT Switches from PwC to KPMG over the Italian Accounts Scandal: The Growing Potential for Accountancy Failures

Today’s post looks at the news that BT, the giant telecommunications company, has switched its auditor for the first time in 33 years due to the failings of PricewaterhouseCoopers (PwC) regarding the recent Italian accounting scandal that cost BT £530 million. Although we spoke about the scandal very briefly here in Financial Regulation Matters before, it will be worth going over the scandal again to examine what the actual failings of the auditing firm were. Upon doing this, it will be good to examine the recent trends affecting the accountancy industry in terms of regulations because, in a move that is echoed in a forthcoming book by this author regarding credit rating agencies, a powerful position does not have to mean one is immune to regulation – in fact, it should be the opposite.

The accounting scandal at the Italian division of BT started in October of last year, when the company reported that it had taken a £145 million hit after uncovering ‘inappropriate management behaviour’ within the division which, the firm declared after an initial investigation, was due to ‘certain historical accounting errors’. However, in January of this year the firm revised that position, stating that the cost would in fact be £530 million, with KPMG – hired to investigate the accounting errors – finding that ‘the extent and complexity of inappropriate behaviour in the Italian business were far greater than previously identified’. Essentially, KPMG found that the performance of the Italian division had been overstated for a number of years, by way of ‘improper sales, purchase, factoring and leasing transactions’, which has now initiated a company-wide review of such practices at BT – in addition, some market forecasters have noted that the final valuation of the damage to BT may be greater than the £530 million the company is hoping for. All of this will, presumably, continue to negatively affect BT’s position but, today, PwC became the latest casualty.

It was announced today that BT had dropped PwC after 33 years, and instead would be working with KPMG. Although PwC has lost a famous account which, last year alone, was worth more than £15 million just for the auditing work, there is a much bigger issue at play. The fact that the issues in the Italian division were uncovered by a whistle-blower, and not the accounting firm, is one thing but, crucially, the headline-grabbing removal of PwC overplays the new structure affecting auditing firms. Stemming from movements within European and British regulatory corridors in 2014, the new framework surrounding the leading accountancy firms dictate, as just one leading example, that ‘listed companies and banks will now have to change auditors after 10 years, although they could keep the same firm for another decade of the work is put out to tender’ – PwC’s contract with BT only ran up until 2020 anyway. What this regulatory move has done, in effect, is smash the notion that the so-called ‘Big Four’ accounting firms – PwC, Deloitte, KPMG, and Ernst & Young – will continue to have cosy relationships with clients that can span for decades. It has been noted that the cultural shift has already begun, with PwC stating that ‘51 companies that have put audits out to tender since October 2012 have switched firms’, although critics have been quick to point out that the process simply creates a ‘auditor merry-go-round’ between the Big Four, with there being only one instance noted in the U.K. so far of a firm going with a second-tier auditing firm in place of a member of the Big Four. There are, as usual, a number of positives and negatives with this recent regulatory move. On the one hand, the move is supposed to increase competition, and also increase the vigilance of the firms, with the premise being that poor performance will see your position affected. Yet, this theoretical set of circumstances alludes to an issue which dominates the work of this author, and that is the notion of actual vs. desired – a framework that applies to almost every financial sector. The regulations want accounting firms to be exposed to competition forces, but the accounting sector represents a ‘natural oligopoly’, in that there are a number of forces at play which preserve the hegemony of the Big Four. Second, the new regulations aim to make firms more accountable, but the most likely result will be a race-to-the-bottom to maximise whatever potion the firm has in the short-term – we see this in the credit rating industry and there is no reason to suggest that the same will not occur in the accounting industry. In fact, imposing that cultural shift on accounting firms as we proceed through the economic cycles, away from cycles dominated by vigilance and towards those that champion ‘productivity’, ‘efficiency’, and ‘wealth creation’ is an extremely dangerous proposition. Yet, the move does indicate something that this author will be championing in the forthcoming book Regulating Credit Rating Agencies: Restraining Ancillary Services – a regulator can take radical steps against an engrained industry; it just has to be the right steps taken from within the right parameters.

Ultimately, PwC are experiencing great damage to their reputation at a time when they are being exposed to manufactured competitive pressures, and the result of that will not be positive. The news that BT had dropped them early, in addition to the recent escape as part of its suggested failures regarding Tesco’s recent accounting scandal, accumulate into the position whereby the firm has a decision to make: take the long road and commit to rebuilding trust via consecutive years of good performance and the avoidance of scandals; or recognise that the firm is part of natural oligopoly that is dominated by ‘name recognition’ and take the short road, one on which there is great profit to be made by circumventing good practice principles to monetise one’s position. It will be interesting to see which road PwC, and the other members of the Big Four take – but the recent history alone of financial gatekeepers facing that decision should provide an early answer if one cares to look hard enough.

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