The audit industry should serve society ... not themselves

The UK has nearly 2.5 million limited liability companies and most require an audit. Between 2002 and 2008, FTSE-100 companies alone paid £2142 million in audit fees.

The auditors collected another £2159m for consultancy services to their audit clients. They advised banks on the formation of special purpose vehicles, tax avoidance schemes, securitisation and structuring of transactions, all of which are central to the crisis.

They then audited the results of their own advice and inevitably said that all was well. When a whistleblower at HBOS drew attention to concerns about the risk profile of the bank, the auditors said all was well. The auditing firm received £23m in fees from the bank for audits and consultancy work.

In 2007, around 100 US mortgage companies succumbed to the deepening financial crisis and were either closed or sold. In April, New Century Financial Corporation, America’s second-biggest subprime mortgage lender, filed for bankruptcy.

In September 2007, Northern Rock was rescued by UK taxpayers. Yet auditing firms continued to issue clean bills of health to all banks for vast amount of fees from auditing and consultancy services. Auditors of banks could not tell the difference between a tent on Brighton beach or AAA security. They too easily accepted management valuations and permitted banks to show toxic assets as good and report profits that did not exist.

At least $5 trillion of assets and liabilities simply vanished from bank balance sheets. These audited accounts would easily have won the Man Booker Prize for Fiction. Yet no auditing firm has been investigated for its role in the banking debacle.

KPMG, Ernst & Young, PricewaterhouseCoopers and Deloitte & Touche audit 99 of the FTSE-100 companies. Between them they audit almost all major banks. Their combined global income of nearly $95bn makes them the world’s 54th-largest economy and provides plenty of resources to colonise regulators and politicians.

They wined and dined Labour politicians to win massive consultancy contracts. Now sensing a change in the political wind they are backing the Conservative Party with cash and non-cash contributions. Yet their fitness to conduct audits must also be questioned.

KPMG have been the subject to investigations by US committees as the firm operated a factory to develop and market tax avoidance and evasion schemes.

In 2005, the firm admitted “criminal wrongdoing” and was fined $456m for peddling tax evasion schemes. Its schemes enabled clients to generate at least $11bn in phony tax losses which cost the United States at least $2.5bn in evaded taxes. A number of its former (they always become former after the events) partners and mangers have been sent to prison.

In September 2009, a former partner pleaded guilty to participating in a conspiracy to defraud the tax authorities.

Ernst & Young have also been under scrutiny by US Senate committees for facilitating tax evasion. In May 2009, a jury found four current and former partners of Ernst & Young guilty of conspiracy, tax evasion and other charges relating to the design, marketing and implementation of tax schemes.

The anti-social practices of these secretive firms are not just confined to taxation. They apply to audits too, the mechanism that is supposed to make companies and their directors publicly accountable.

In 2006, three former accountants at ChuoAoyama PricewaterhouseCoopers, the Japanese arm of PricewaterhouseCoopers, were found guilty of lying in conspiracy with executives of cosmetics maker Kanebo. Rather than calling directors to account, the firm’s executives helped them to falsify accounts.

The Japanese regulators suspended the firm’s licence and soon the firm had to close its doors as public confidence ebbed away. More recently, the firm is facing meltdown in India over its audit of computer software giant Satyam.

Deloitte & Touche have been in the dock over its audit of Adelphia. In August 2009, the US regulators fined one of its former partners for allegedly helping Navistar, one of the firm’s audit clients, to avoid restating its erroneous financial statements.

The above is only a small amount of the mounting evidence that poses questions about the integrity, effectiveness and independence of major accounting firms. The failures are manufactured by the organisational culture that prioritises profits at almost any cost.

The firms have become masters of “bending the rules”. It is hard to think of any headline scandal that has been brought to public attention by auditing firms.

Yet the UK regulators have been twiddling their thumbs. This is not surprising as they are populated by personnel from the same accounting firms. There are no auditing standards about the public accountability of auditing firms.

The banking crisis is an opportunity to remove major accounting firms from the audit of banks altogether. Such audits should be conducted by a designated statutory regulator on a real-time basis.

Thus auditors can be the eyes and ears of the regulators and cannot hide behind the assumed duty of confidentiality to audit clients. Such auditors cannot be consultants to companies. These independent audits can be funded by a levy on banks.

Unlike the present auditors they should owe a “duty of care” to the regulators and bank depositors. The National Audit Office should examine the files of auditors to ensure that they are efficient, effective and deliver value for money.

Audit files should also be available for inspection by the House of Commons’ Treasury Committee.

The above is a small, but a necessary step to cleaning up the auditing industry and ensuring that it serves socially desirable purposes rather than lining its own pockets.

Prem Sikka is Professor of Accounting at the University of Essex