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Heart of darkness
Accounting firms have penetrated the UK state and their many antisocial activities are going unchecked, Prem Sikka
There is something very odd about the way UK governments deal with administrative failures. In earlier times, rulers called upon obedient high-priests to manage their crises. In return for high rewards and protection, the priests engaged in some ritualistic practices and absolved their masters of all wrongdoing. The mutual back-scratching continued.
Rather than creating independent and accountable institutional structures to investigate maladministration, politicians now call upon consultants, the new high priests. A large chunk of the £2.8bn public sector contracts go to accountancy firms and they are not in the habit of blaming themselves or their paymasters for failures.
The outcome of Kieran Poynter's (chairman of accountancy firm PricewaterhouseCoopers (PwC)) investigation into the saga of the data disks lost by Her Majesty's Revenue and Customs (HMRC), is eagerly awaited. Big accountancy firms second staff to most major government departments and have an "inside" track on public policymaking. At £540 an hour (pdf, see p Ev22), the modern high-priests don't come cheap. The relationship between the state and big accountancy firms is too close and has a nasty smell to it. The firms prop up confidence in companies with soothing audit reports. During the years of the Conservative administration, they became key players in the ideological project of privatisations. They collected huge fees from the privatisation of railways, buses, steel, gas, electricity, water, telecommunications and everything else. Most of the privatised companies were grossly undervalued and facilitated a huge transfer of wealth from the taxpayer to private owners. These class warriors were also the architects of the private finance initiative (PFI (pdf)) that guaranteed huge profits to companies and themselves and kept the loans off the government's books. The firms became central to government policies and acquired friends in high places.
The revolving doors between accounting firms, politicians and senior civil servants cement the close relationship. The informed wisdom in business circles is that former ministers provide that extra degree of understanding when dealing with government departments. Before his resignation from the post of the Secretary of State for Trade and Industry, Peter Mandelson granted liability (pdf) to accounting firms. Then within days of his resignation he became an adviser to Ernst & Young. Sir Malcolm Rifkind, a former Conservative minister, is considered to be a pioneer of PFI schemes. In 2003, he became an adviser to PwC. A former head of the Inland Revenue (now HMRC) heads a PwC advisory unit and a former PwC partner is head of the tax anti-avoidance at HMRC. The former head of the UK Treasury's transport team is now KMPG's director of corporate finance. No doubt everything is above board and in accordance with the terms of liberal politics, but a public scrutiny of the power, influence and money flowing through these revolving doors is long overdue.
A US Senate report (pdf) concluded (p7) that "PricewaterhouseCoopers sold generic tax products to multiple clients, despite evidence that some... were potentially abusive or illegal...". The firm claims to have global standards and also operates in the UK, but no politician called for an inquiry here. The firm advises the Conservative party on taxation.
In the US, KPMG admitted to "criminal wrongdoing" and paid $456m fine in the largest-ever tax fraud case. A UK tax tribunal declared a VAT avoidance scheme (pdf) marketed by KPMG to be unacceptable. The firm advises the government on taxation.
A UK tax tribunal declared a tax avoidance scheme designed by Ernst & Young to be unacceptable. A Treasury spokesperson said, "This was one of the most blatently abusive avoidance scams most of recent years", which could have cost the taxpayer over £300m a year. No prosecutions or inquiries have followed.
The US administration completed an investigation of Enron, the disgraced US energy giant, within five months of its demise and brought charges against its auditor Arthur Andersen. The UK goes at a snail's pace. In August 2005, an investigation into MG Rover, audited by Deloitte & Touche began. An inquiry into the collapse of Farepak, audited by Ernst & Young, was announced in June 2007. So far no reports.
The late Robert Maxwell, lauded as a "great character" by John Major, then Conservative prime minister, looted over £400m from his employees' pension fund. His business empire was audited by Coopers & Lybrand (now part of PricewaterhouseCoopers). In 2001, some 10 years after the appointment of inspectors, the government eventually published its report. The report contained strong criticisms of auditors, but the auditing firm was not prosecuted though the accountancy trade associations levied a paltry fine.
The Bank of Credit and Commerce International (BCCI, pdf), audited by Price Waterhouse, was the biggest banking fraud of the 20th century. In July 1991, it was closed down by the Bank of England. In 1992, a report by US Senators John Kerry and Hank Brown concluded (ch 10, p 276) that "British auditors... had... become BCCI's partners, not in crime, but in cover up". Yet to date, the UK has not launched an independent investigation of the BCCI audits.
The brief evidence cited above shows that there is an unhealthy relationship between the UK state and major accounting firms. Accounting firms have penetrated the state and their many anti-social activities go unchecked. Despite dodgy audits and dubious tax avoidance schemes no UK government has ever prosecuted any major accounting firm. Is it any wonder that the public confidence in political institutions is low?
How Coopers lost the plot on Maxwell, but kept its heads
Heather Connon explains an auditor's job. And it's not to detect fraud
Observer, Sunday February 7, 1999
The complaints 'reveal shortcomings in both vigilance and diligence' and 'a failure to achieve an appropriate degree of objectivity and scepticism, which might have led to an earlier recognition and exposure of the reality of what was occurring...'
'Earlier omissions may have fostered a climate in which deception was easier to perpetrate, as it became more necessary if the empire was not to be brought down by its borrowings and need for cash...The firm lost the plot.'
These are just two of the damning findings of the Joint Disciplinary Scheme of the Institute of Chartered Accountants into the conduct of Coopers & Lybrand, auditors to most of the public and private companies in the business empire controlled by Robert Maxwell.
The empire collapsed in the weeks following his death in 1991, revealing a web of stock-lending, illegal borrowing and undisclosed dealings between the various companies, designed to conceal the fact that debt in the empire had spiralled out of control.
The report accuses Coopers & Lybrand - now merged into PricewaterhouseCoopers (PWC) - of being too close to Maxwell, who was described by the Department of Trade and Industry in 1971 as unfit to run a public company. It also attacks the auditors for trusting the representations of Maxwell and his senior executives 'without adequate investigation and consideration'.
Yet not a single head has rolled. One Coopers partner died during the investigation, but the other four remain in place. Of the £3.4 million penalty suffered by the firm and the four surviving partners, only £1.2m is in fines; the rest is the costs of the inquiry.
The firm is being sued by Grant Thornton, which took over that part of the receivership from Price Waterhouse after the merger left them with a conflict of interest, but this case will not be heard until at least 2002. And eight years on, there has been no proper explanation of the failure of the Coopers audit to alert anyone to what was going on, nor a guarantee that it will not happen in the future.
The collapse of the Maxwell empire was not the only scandal to hit auditors in the Eighties. Remember Barlow Clowes, Polly Peck, Bank of Credit & Commerce International or British & Commonwealth. While all have been followed by some payment by auditors, these were invariably out-of-court settlements aimed at curbing spiralling legal costs and, perhaps more importantly, ending the bad publicity that dogs a firm associated with a corporate collapse and subsequent legal action. In no case has an auditor admitted that it was wrong or that it should have spotted, and reported on, the disaster in the making.
So if auditors can't spot when a company is about to collapse, what exactly is their job? Why do shareholders pay such huge sums for audits when the clean bill of health the accounts are given can be so misleading?
Auditors have a ready response: the expectation gap. They've been using it since the end of the last century, when a judge decided their role was to be watchdog, not bloodhound. The expectation gap means that, while the public (and pensioners, shareholders and creditors) think auditors should be able to detect fraud, auditors know they can't and are adamant that no one can force them to.
Most frauds, they point out, involve a number of people - often senior executives - colluding to cover their tracks. Unless the collusion is so obvious that it can be spotted straight away, in which case the company should spot it, it will be impossible for an auditor, there for only a brief spell each year, to detect. Indeed, a survey by accountant Ernst & Young found that three in five frauds are uncovered purely by chance, while less than 10 per cent are detected by auditors.
The auditor can't check everything. He or she has to look at only a sample of transactions, and assess how easy it would be for staff to circumvent management's internal controls. And he is only looking at 'material' transactions - usually defined as between 5 and 10 per cent of expected profit for the year. Prem Sikka of the University of Essex, a campaigner for stiffer audits, dismisses such excuses. 'Auditors in the public sector have a statutory duty to detect and report fraud. In the financial sector, since BCCI, there has been a statutory duty to report fraud to the authorities - but not to detect it. Elsewhere, there is no duty at all.'
Sikka believes case law, particularly the Caparo judgement of 1990, which made auditors responsible only to the company as a whole, not to shareholders individually, nor third parties, means they have no 'economic incentive' to improve procedures, as they can not be held responsible for failures.
The Joint Disciplinary Scheme report says that much has changed since the Maxwell collapse. But most of the changes take the form of shouting rather more loudly about what the public should expect, rather than changing the duties of the auditor. PWC managing partner Peter Hazell points out that the problem with Maxwell was not the companies' procedures, but the fact they were not complied with. PWC has, he says, introduced a number of changes in an attempt to ensure this improves in the future. These include: specialist pension fund auditors; tightening the role of the independent partner who reviews the conduct of each audit; encouraging staff to be more sceptical and to insist on independent corroboration; and being more selective about its clients - it has resigned from 50 in the past three years.
Jon Grant, technical director of the Auditing Practices Board, which is responsible for setting standards for auditors, lists other measures affecting the profession as a whole, including the creation of his board. Since its inception, the board has created a whole new set of standards, including one which, it claims, was the toughest available on fraud until the US authorities went one step further. But it has also made sure that there is no doubt who is responsible for a company's internal controls: the directors.
A raft of corporate governance reports, from Cadbury to Hampel, have re-defined the role of non-executive directors and audit committees, making them stronger and more independent. The aim is to give suspicious auditors somewhere to go to raise the alarm. And the partner in charge of a company audit must now be changed regularly.
The APB is, however, attempting to extend the fraud debate with a consultation document. This acknowledges that one way of closing the expectation gap is to put more responsibility on to the auditor. That could mean encouraging auditors to be more sceptical,requiring them to gather more evidence to support their conclusion, or to report separately on all items they could not corroborate independently.
But it warns: 'The changes set out in this section will not eradicate fraud nor lead to all frauds being detected. But... [they] could provide more assurance that fraud will be detected.' The consequences, it warns, are higher costs and lengthier audits. Neither companies nor their shareholders have shown much enthusiasm for that.
Holding audits to account
UK companies spend nearly £1.5bn each year on audits, but these offer little protection to stakeholders. It is time to replace them., Prem Sikka
UK companies spend nearly £1.5bn each year on audits of their financial statements. Yet episodes like Hollinger, Farepak, Barings, Ahold, Equitable Life, MG Rover, Parmalat, Enron and others suggest that company audits offer little protection to stakeholders. It's time to replace them.
A common understanding is that auditors are independent of the company and its directors and thus in a position to make impartial judgements. This is one of the biggest hoaxes of all time. Company auditors are hired, fired and remunerated by directors though their decisions are rubber-stamped by shareholders. Many auditors also sell tax avoidance and a variety of consultancy services to client companies. This gives them a direct interest in corporate transactions and they have rarely exposed any shady dealings. Despite having statutory access to almost all records, officers and employees of the company, auditors deny obligations to detect and report fraud. Their files are not available to any stakeholder to see what they knew.
Though auditing firms carry the soubriquet "professional", they are commercial organisations. In pursuit of profits, they continued to accept Maxwell, BCCI, Enron, WorldCom, Transtec, Versailles Group, Hollinger and others as clients. They are adept at prioritising the interests of directors above those of any other stakeholder. In the case of the frauds by Robert Maxwell, page 328 of a report by the Department of Trade and Industry (DTI) inspectors noted that the auditing firm consistently agreed accounting treatments of transactions that served the interest of Maxwell and not those of the trustees or the beneficiaries of the pension scheme, provided it could be justified by an interpretation of the letter of the relevant standards or regulations. The audit firm's strategy, as noted on page 381 of the DTI report, was summed up by a senior partner who told staff that, "The first requirement is to continue to be at the beck and call of RM [Robert Maxwell], his sons and staff, appear when wanted and provide whatever is required".
Scholarly research shows that nearly 60% of audit staff admit to either falsifying audit work, or not doing it at all. Audits are time and labour intensive. To boost their profits, auditing firms continue to reduce time budgets. They hope that audit trainees will work weekends and evenings for nothing to finalise the audit. The routinised audit work is boring and time consuming. To ensure that they are not seen to be unproductive or over budget, audit staff avoid awkward looking items and often pretend to have checked items that have not even been examined. Over the years, I have forwarded this research to the Department of Trade and Industry (DTI) and the UK auditing regulators, but none have ever examined the organisational values of auditing firms.
The threat of lawsuits can force auditors to be more vigilant, but this has been diluted. Generally, auditors only owe a "duty of care" to the company as a legal person rather than to any individual shareholder, creditor or other stakeholder. As page 19 of a UK Treasury-sponsored study (pdf) notes, individual stakeholders cannot successfully sue auditors even when they can show that "the auditors had been negligent". Most lawsuits against UK auditing firms are brought by other accountancy firms, acting in their capacity as liquidators. Ordinary stakeholders rarely get much out of this.
Auditing firms already trade as limited liability companies and limited liability partnerships. The prospects of making them accountable for poor audits are further eroded by "proportionate liability" introduced by the Companies Act 2006. This enables directors and auditors, subject to shareholder approval, to negotiate limits to auditor liability, this makes it even harder to bring negligent auditors to book. The policy was first introduced in the US in the mid-1990s and played a key role in the Enron and WorldCom audit failures. Now major firms are campaigning to place an artificial "cap" on auditor liability and their US political donations are about to pay high dividends. The EU and UK are keen to follow suit. Under a cap the outcome of lawsuits would have no relationship to the extent of auditor negligence, or the losses suffered by that negligence.
Serious doubts about the auditors' ability to deliver good audits are also created by business developments. It is doubtful that auditors can effectively audit banks operating from 140 countries. The traditional ex-post audits cannot perform any meaningful checks on the world of instantaneous transfers of money. Neither are auditors able to deal with complex financial instruments. Many major companies manage their risks by placing clever bets on the movement of exchange rates, interest rates and prices of commodities. Depending upon the outcomes, the value of such contracts (derivatives) can range from zero to several millions. The collapse of Long Term Capital Management (LTCM) showed that even the Nobel Prize winners in economics could not work out the value of such financial instruments. Auditors are certainly not equipped with such skills and are simply rubber-stamping the figures produced by management.
Company auditors have shown little interest in becoming independent and have fought tooth and nail to preserve their right to sell consultancy to audit clients. The regulators have shown little interest in protecting the interests of stakeholders or looking at the internal workings of auditing firms. The liability regimes encourage inertia and audit failures. Traditional audits cannot audit banks or the financial statements of major corporations. Yet people do need to protect their savings, pensions and investments from fraud. So rather than constantly trying to revise the traditional auditing model and rescue the failed technology, alternatives need to be developed.
One possibility is to abolish the annual statutory audit and require all companies to have insurance cover equivalent to (say) twice the value of their assets so that defrauded stakeholders claims can be satisfied. £1.5bn can buy a lot of insurance cover and details would be publicly known. To minimise the risk of misinformation, laws would need to be changed to make all company directors personally liable for knowingly publishing misleading financial statements. Corporate laws will need to be strengthened to ensure that companies publish the required information. Of course, insurance companies need to assess the fraud risks and may use the services of accountancy firms to make assessments of corporate internal controls and fraud potential. It is extremely unlikely that, under these arrangements, accountancy firms would be able to deny any obligations to look for fraud and stakeholders will not have to put up with the pretensions of independent auditors.
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