Wednesday, 16 August 2017

Two “Big Four” Auditors Fined for Misconduct: A Persistent Problem Being Met With Persistently Lenient Punishment

Today’s post looks at the news that KPMG has been fined by the U.S. Securities and Exchange Commission (SEC) for ‘misinforming’ investors about the value of a certain company. This follows the news from the U.K. where the Financial Reporting Council (FRC) have fined PricewaterhouseCoopers (PwC) for ‘extensive misconduct’ relating to its audit of a professional services group. This recent flurry of regulatory activity has led some to discuss the ‘growing concerns’ regarding the quality of the Big Four’s output, but in this post we shall see that it is a surprise that this behaviour is not expected of the Big Four, and that the regulatory response should certainly be expected.

Only very recently here in Financial Regulation Matters did we discuss the ever-growing problem of accounting firm quality standards, with it being suggested that Andrew Tyrie may be looking to establish some sort of oversight board to further regulate the accounting industry. These suggestions followed on from what is being imagined as a new regulatory wave coming the accounting industry’s way after Brexit, but recently there have been a number of instances which suggest the Big Four firms – PwC, Deloitte, Ernst & Young, and KPMG – are beginning to lessen their standards on a systemic level (this will always be the case with a financial oligopoly). In May of this year, the FRC handed out its highest ever fine, this time to PwC, to the tune of £5m. This was for serious failings in the auditing of Connaught, a social housing maintenance group, for which the FRC proclaimed that it has ‘severely reprimanded’ PwC, with the Connaught fine coming just a year after the regulator had to fine PwC £3m for the same thing for its audit of Cattles, a financial services group. Yet, rather predictably, that severe reprimanding had little effect, and now just 2 months on from Connaught, the FRC has fined PwC a new record total of £5.1 million for its audit of RSM Tenon, a professional services group that went into administration in 2013. Strangely, the regulator continued with the narrative that the fine represented a ‘severe reprimand’ again, with PwC admitting to five separate instances of misconduct – perhaps the regulator has a new definition for ‘severe reprimand’. This all follows on from fines for PwC for its role in a recent audit of Merrill Lynch, and also the Ukrainian lender PrivatBank; clearly, the reprimands are not working.

The growing concerns regarding the quality of the Big Four’s output have been flagged up in the media because of the recent fine given to KPMG by the SEC, totalling $6.2 million. The fine, which was in relation to the firm’s valuing of Miller Energy Resources (a Tennessee-based oil and gas company), punished the auditor for ‘grossly overstating’ the value of the company, even to a point of overvaluing certain assets by more than 100 times their actual value (!). As part of the fine, the auditor agreed to improve its quality control mechanisms, but the ludicrousness of that statement, coming from a member of the Big Four, beggars belief. Yet, these fines, and the sentiment that is attached to them, provide an excellent demonstration of the problem at hand.

If we look at the companies who the auditors have failed to properly audit, there is a distinct correlation. These ‘financial services’ firms are prime targets for the Big Four’s array of ‘consultancy services’, which serve in the same way the Credit Rating Agencies’ ancillary services do, in that the additional services are worth much more to the auditors than the actual audits themselves. This is a common problem within the world of financial gatekeepers, and one that is widely recognised. Yet, in the decisions of the regulators above, the issue is not addressed at all, and all that we see are nominal fines and throw-away comments like ‘severely reprimanded’. Speaking in the Financial Times, Emeritus Professor Prem Sikka stated that ‘a £5m fine is less than half a day’s work for PwC’, and he is absolutely right – there is simply no way that this can be regarded as a deterrent. So, if the fines cannot be counted as a deterrent, then what are they? In essence, these fines represent a pacifier for the public, and that regulatory must stop as we oscillate away from the Financial Crisis.

In the aftermath of the Crisis, the Big Four were criticised, but that criticism could hardly be heard against the wall of criticism aimed towards the banks, mortgage companies, and rating agencies (and rightly so). It needs to be established more clearly and more often that the auditors had a very important role in facilitating the crisis – this should be a given, given their centrality to the financial marketplace. Yet, this is not really the case, and although the transgressions of the Big Four are steadily creeping back into the public consciousness, where they belong, there is a growing problem on the horizon. New rules which dictate that large firms must put their auditing accounts out to tender every ten years has seen the Big Four switch their focus from the auditing section of their business (which is, by far, the least lucrative) and turn their attentions towards the consultancy side of their business (which is, by far, the most lucrative). This attachment to the firm’s consultancy arms is directly at fault for a number of the failings of the industry, in that it makes sense that the firms would pressure their clients to take consultancy services, or vice versa clients can impart influence upon the threat of taking their business to an oligopolistic competitor. The theoretical deterrent is that the firms would not want to risk either their reputation, or their standing with the regulator, but neither of these apply – the oligopolistic structure protects them from competitive pressure, and the regulators, in levying £5m fines, confirm for the auditors that they will not be punished for transgressing. Simply put, until the regulators join reality and begin to fine the firms excessively, there will be no change in the culture of these societally-vital financial firms.

Keywords – Accounting, Audit Firms, KPMG, PwC, SEC, Financial Reporting Council, Fraud, Financial Regulation, @finregmatters

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