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LOCATION: abc.net.au > Lateline > Archives URL: http://www.abc.net.au/lateline/s595990.htm
Broadcast: 1/7/2002
Wall Street rues accounting scandals
As economists win back from Wall Street share analysts the right to tell the history of the bubble economy of the 1990s, you may see the phrase "collective madness" repeated over and over again. And they'll have some fine examples to choose from when trying to illustrate that point. Prime among them will be 'Enron', and now 'WorldCom'. And the questions that'll be asked over and over again will be -- how was this allowed to happen? What happened to the auditors whose job it was to protect the public interest and make sure the books were not cooked?
TONY JONES: As economists win back from Wall Street share analysts the right to tell the history of the bubble economy of the 1990s, you may see the phrase "collective madness" repeated over and over again.
And they'll have some fine examples to choose from when trying to illustrate that point.
Prime among them will be 'Enron', and now 'WorldCom'.
And the questions that'll be asked over and over again will be -- how was this allowed to happen?
What happened to the auditors whose job it was to protect the public interest and make sure the books were not cooked?
Our next guest says corporations have been left to effectively regulate themselves and that auditors have become complicit in the great game.
Professor Prem Sikka is the author of a new book, Dirty Business: the unchecked power of major accountancy firms.
And I spoke to him in London a short time ago, just before the book was launched in the House of Commons.
TONY JONES: Prem Sikka, why do you say that more Enron and WorldCom style scandals are inevitable?
PROFESSOR PREMIER SIKKA, ESSEX UNIVERSITY: Well, we have to look at the cultural values by which the business people live.
We live in a world where the idea of deregulation and enterprise culture has been dominant, and people are told as long as you make money, that is okay.
People are fairly used to ducking and diving, trying to avoid rules and regulations to enrich themselves and there is a dominant belief that the company executives should be paid by reference to the profits they publish, and that gives them economic incentive to massage the numbers, because the more they massage the numbers, higher salaries, higher bonuses, higher share options they receive.
So that people are actually being rewarded on a system which encourages exactly what many of us are being concerned about.
TONY JONES: But we've never seen fraud on this sort of scale before.
And I'm wondering is this about the new economy bubble, and the extraordinary and unreachable expectations that were put on company profits and what they call "the new paradigm" -- that ordinary judgments of a company just simply didn't matter any more?
PROFESSOR PREM SIKKA: Well, I think as companies have become larger, inevitably scandals would be larger as companies have become global, therefore, it's inevitable that the impact of WorldCom -- and World'Con', is it
- and Enron will be felt worldwide.
And basically the captains of industry have been able to secure fairly ineffective systems of regulations for themselves and they have surrounded themselves with advisers who are willing to enable them to rob companies.
We have to remember that all these frauds have been carried out by people who are not poor.
They've been highly paid, highly educated, living in leafy suburbs, driving the most expensive cars, sitting in plush city centre offices devising processes which have resulted in daylight robberies.
And, you know, you no longer have to go out and rob anything, you simply hire a firm of accountants to help you.
TONY JONES: You don't then think that this is a sort of pathology of the new economy, that this has come with the new high-tech bubble economy?
PROFESSOR PREMIER SIKKA: Well, I think that has clearly aided it, but we must not forget that even before this new economy, we've been having worldwide scandals.
When you look at the UK for example, in 1991, we had the Bank of Credit and Commerce International, which was the biggest banking fraud of 20th century.
The Bank of England closed the BCCI bank down in 1991.
To this day, 11 years later, the British Government has failed to commission an independent inquiry into the fraud and into the audit failures.
So the problem is that governments are protecting major corporations and accountancy firms.
When you look at the US, you see that the SEC's funding has been eroded and it's not really been in a position to call companies to account.
Even then, the SEC has done a good job, despite the limitations on its funding.
Over the last two, three years some 700 companies have been forced to restate their accounts in the US, and in no case did any accountancy firm blow the whistle.
TONY JONES: Let's go back to WorldCom because the former CEO of WorldCom, Bernie Evers, seems to be almost in a category of his own.
How much blame in the end is going to be laid specifically at his feet, do you think?
PROFESSOR PREM SIKKA: Well, I think someone should throw the book at him.
Clearly, the directors of major companies are culpable, but I have to remind people that no-one is actually born bad.
We all have the same DNA structure.
It is the system, the culture, which makes people bad.
This is why we need good regulation to curb people's anti-social tendencies.
We have to make sure that people do fear being caught, being checked, being fined, being imprisoned.
But in a world of deregulation, those kind of things have become a dirty word.
And now we are seeing the cost of deregulation.
People imagine that if you regulate something, it costs money.
Now we are seeing that if you don't regulate, a lot of innocent investors, creditors, employees and pension scheme members are suffering all over the world.
TONY JONES: What sort of regulation should there have been in the WorldCom case which might have stopped that from happening, because in that case it seems extraordinary that $4 billion seems to have gone completely unnoticed in the profit figures by the auditors?
PROFESSOR PREM SIKKA: Well, I don't think we are completely going to stop these things unless we change the cultural values by which the big business operates.
But, meanwhile, if you are going to enter Sumo wrestling, you have to make sure you have good protection, good cover, and that good protection, good cover needs to come at a number of levels within companies.
If you look at WorldCom, Enron and other scandals, every one of them had an audit committee, every one of them had non-executive directors, but they were all friends of the directors.
And these guys, who are non-executive directors, were simultaneously directors of tens and hundreds of other companies, barely spending more than three, four hours a week or a month even looking at each company's affairs.
They were totally ineffective.
We need to change the way the companies are governed.
We need to make sure that directors are elected by shareholders and employees.
We need to make sure that the non-executive directors are elected by shareholders and employees so that we give employees an incentive to blow the whistle.
We give employees a reason to take more interest in the affairs of a company.
We need also to change the regulatory system.
And we need -- you know, we are trying to deal with major world corporations, so therefore we need to make sure our regulatory system is beefed up and the punishment has to be quick and fairly hard.
And I don't think we can necessarily rely on major accountancy firms that much because time and time again they have let people down.
And in a book I'm releasing today, we are reporting that some of the biggest accountancy firms in the world have been laundering money, engaged in tax evasion, bribery.
And I think we need to ensure that at the end some kind of truth is told.
And we should be willing to allow major organisations, like the Securities Exchange Commission or their equivalents all over the world -- inland revenue authorities, the taxation authorities and other public bodies -- to do the audit, because these people will not agree to become auditors and simultaneously consultants and advisers to the management.
And what we've been finding is, in accountancy firms, one floor does the audit, another one dreams up creative accounting and financial engineering, another one is dreaming up on how to avoid the public humiliation of companies.
And these firms have been playing all sides of the street, and that is simply not right.
TONY JONES: Well, to what degree, though, can you break up the relationship between corporations and their auditors in a free market?
PROFESSOR PREM SIKKA: Well, first of all, I'm not sure that we have a free market, when the world accountancy is dominated by four or five firms and almost anything you look at you will find more than 50 per cent of the world's trade is carried out by 200 companies, and you will find that 50 of the world's largest -- if you look at the 200 top economies, 50 are actually corporations.
So I'm not sure that we are necessarily talking about a free market in the classic sense.
What we are looking at is concentration of corporate power.
And it should not be beyond any government in any part of the world to introduce regulation which is independent, ie audits are really done by independent organisations.
At the end, what really matters is protection for the people.
We are not running audits or publishing accounts to enable accountancy firms to make money.
We have lost sight of these things.
TONY JONES: Finally, Prem Sikka, have the equity markets actually weathered this storm, as some people are saying now, or is there more to come?
The doomsayers, for example, are suggesting this could be, or looks very much like, the series of events that led up to the Great Depression.
PROFESSOR PREM SIKKA: Well, I think the equity markets would go up and down, and clearly, the government ministers and regulators are trying to talk the markets up, and a good thing, as well, because many of our pension moneys are invested in various companies.
But even when the equity markets go up, the damage is done to people.
For example, lots of people have lost their jobs or will lose their jobs.
Banks will be writing off bad debts, which could result in a credit crunch for all of us.
Insurance companies will be forced to meet some claims, which mean all of us will be paying higher insurance premiums next year, or within the next few months -- on our cars, on our houses, on our contents, on our travel, and everything else.
And many of the pension funds actually will be writing off their investments, which mean many people will actually receive a lower pension.
So even if the markets bounce back, that does not mean that the damage to ordinary people has not been done.
TONY JONES: We will have to leave it there, Prem Sikka.
Thank you very much for taking the time to join us tonight on Lateline.
PROFESSOR PREM SIKKA: It's been a great pleasure.
Toothless watchdogs
The watchdogs auditing our financial institutions haven't been able to stave off the sub-prime crisis. Their failure will hurt millions of people, Prem Sikka
The deepening sub-prime crisis can, like past crises, be laid at the door of opaque accounting practices. The pre-Enron technique of off-balance sheet accounting, which enables companies to understate assets and liability and flatter their profits, is widespread. None of the watchdogs barked.
The corporate dominated Financial Services Authority (FSA) admits that it "did not pay enough attention to the build-up... of assets off-balance sheet." The Financial Reporting Council (FRC), responsible for good corporate governance and financial reporting, towed a similar line.
The accounts of companies in the sub-prime debacle received a clean bill of health from auditors, who received millions in fees, but within a few short weeks have been exposed as fiction worthy of the Man Booker prize. After Enron, WorldCom, Parmalat, Ahold, Barings and other headline episodes, auditors promised to improve the quality of their work. Have they?
Audit quality cannot be observed by an outsider as audit files are not available to stakeholders. Instead, regulators examine samples of auditor files to assess the quality of audit work. Their notion of quality is compliance with auditing standards, largely shaped by the industry itself. Previous scandals have highlighted the deficiencies of such benchmarks.
The FRC inspects a sample of auditor files to assess the quality of audit work by major UK accounting firms. Without publishing any reports on specific auditing firms, or explaining the current troubles it considered "the quality of auditing in the UK to be fundamentally sound."
In the US, after the Enron and WorldCom scandals, the 2002 Sarbanes Oxley Act led to the creation of the Public Company Accounting Oversight Board (PCAOB). It inspects samples of audit files and publishes extracts from its firm specific reports. These reports do not name the companies who may have received problem audits, but provide some insights into the quality of audit work performed by PricewaterhouseCoopers, Deloitte & Touche, KPMG and Ernst & Young. These firms audit almost all major UK and US banks and claim to have common global standards of auditing.
For 2004, 2005 and 2006, the PCAOB has flagged 65, 47 and 29 problem audits delivered by the big four firms - PricewaterhouseCoopers, KPMG, Deloitte & Touche and Ernst & Young. The initial high numbers may indicate the poor quality of audits at the beginning of the Sarbanes Oxley regime. The numbers game does not tell us anything about the significance of the failures, but each one can have negative consequences for thousands of shareholders, depositors, employers and taxpayers.
The PCAOB's 2006 report on PricewaterhouseCoopers stated that at one company "the firm failed to adequately test mortgage servicing rights and their amortisation... key inputs to the amortisation calculation, such as the weighted average lives of the underlying loans and the carrying values of the mortgage servicing rights" (from pages 4 and 5 of the report). On another audit, the report stated that the firm failed to "properly design and execute tests of internal controls... failed to sufficiently test whether revenue was recognised in the proper period... failed to perform substantive audit procedures on certain critical estimates inherent in the accounting for long-term contracts" (from page 6).
The 2006 report on KPMG stated that the firm "did not perform procedures to test whether certain data the issuer provided to the valuation specialist were complete, accurate, and relevant". On another audit the firm "failed to evaluate whether the issuer's use of hedge accounting for two kinds of forecasted commodity purchases with forward contracts was appropriate. The firm failed to obtain evidence to evaluate management's assertion that the hedges were effective..." (from page 7). On another audit in some areas the firm failed "to obtain sufficient competent evidential matter to support its audit opinion" (from page 8).
The 2006 report on Deloitte & Touche noted that in one case a company had working capital deficit, two consecutive years of net losses, negative cash flows from operations, and declining gross margins and that there "was no evidence in the audit documentation, and no persuasive other evidence, that, other than through inquiry of the issuer, the Firm, in its evaluation of the issuer's ability to continue as a going concern, had tested significant elements of management's plans for dealing with these conditions, including the forecasted cash flows" (from page 7).
The 2006 report on Ernst & Young reported that in one case the firm failed to identify departures from accounting rules that it should have identified and addressed before issuing its audit report. On another audit it also "failed to test a sufficient portion of supplier rebates receivable, deferred rebate balances, and cost of sales adjustments". The report states that when examining debtors or accounts receivables, the firm "failed to adequately evaluate the extent of the errors" (from page 6).
Of course, the firms contest the PCAOB conclusions. The regulator's benchmarks are also problematical because they only check compliance with the industry's own standards and ignore the impact of organisational culture on the production of audits. For example, it is well documented that to improve their profits firms often reduce the time allocated to complete an audit. One consequence of this is that audit teams ignore awkward looking items and also falsify audit files.
The sub-prime crisis has once again shown that all the watchdogs are too close to the very interests that are to be regulated and are thus unable to deliver. Will any government break this mould?
Our irregular regulators
Without better reform of the UK's political institutions for taming corporate power, a durable regulatory system cannot be developed, Prem Sikka
The Treasury select committee's (pdf) report on Northern Rock is critical of the Financial Services Authority (FSA). Its quick fixes rearrange the regulatory deckchairs, but do not offer a deeper analysis of the regulatory problems.
The UK has failed to develop an effective independent regulatory system. Large swaths of public policymaking have been handed to unelected and unaccountable corporate elites. In 1997, a UK government report on Guinness Plc characterised the City of London as a place with "cynical disregard of laws and regulations... the cavalier misuse of company monies... a contempt for truth and common honesty". Yet there has been no fundamental change in regulatory culture.
The main task of any business regulator should be to make corporate power accountable. Companies are focused on pursuit of private profits, at almost any cost. Since profits play a major part in the calculation of executive remuneration, company directors have incentives to cook the books. As the average tenure of FTSE 100 chief executives is around four years, and declining, there is every incentive to indulge in high-risk and even dubious activity to maximise personal gains.
The FSA and the Financial Reporting Council (FRC) are all dominated by the corporate interests they are supposed to regulate. The FSA permits companies to sell financial instruments without ever testing them for their potential to bring mass destruction. It did not scrutinise the business models developed by banks. Neither the FSA nor the FRC said boo to any company that failed to fully report their toxic investments, or auditors who approved such accounts. Rather than regulators, they have been busy acting as cheerleaders.
A necessary condition of effective regulation is that there should be a distance between the interests of the regulators and the regulated. The regulators should primarily be concerned about the welfare of citizens, consumers and society generally. They need to have different values, vocabularies, agendas and priorities. They should not have a cosy relationship with the regulated. Yet the regulators are too close to corporate interests. They do not owe a "duty of care" to anyone affected by their myopia. They routinely hold discussions with corporate barons and neglect victims of corporate misdeeds.
With complexity of commercial activities, regulators need some expert input and thus need to consult the relevant corporations and industries. However, that should not result in domination by technical experts. As a crude analogy, consider the case of nuclear energy. In building any reactor and power plant, nuclear experts should be consulted, but whether we should have nuclear energy is a social and political decision. Since the consequences of nuclear power affect all citizens, bodies representing wider social interests should make the ultimate decision. The same logic should apply to all public policymaking. The industry experts should not be in the majority on any regulatory structure. Thus others need to be persuaded to build a consensus, rather than like-minded technical experts agreeing on things and organising wider social issues off the political agenda. All regulatory bodies should be open and have a plurality of interests represented on them. Their correspondence, minutes and background papers should be publicly available.
The possibilities of constructing responsive regulatory structures are, however, constrained by systemic forces. With the state's reliance on private capital to stimulate the economy, its interests have become central to all domestic and foreign public policymaking. At the same time, governments seek to persuade people that capitalism is not corrupt and that governments can tame the worst aspects of corporate power. These contradictions create space for developing responsive regulatory structures, but the possibilities are stymied by the close links between corporations and political institutions.
Big companies fund political parties and always manage to get a return on their investment. Corporations offer lucrative consultancies and jobs to former and potential ministers, to advance their narrow commercial interests. Senior civil servants and company executives also move through the revolving doors to build ideological consensus on business friendly policies. The interests of consumers and citizens are easily marginalised.
The political system does not encourage governments to listen to critical voices. A minority share of the votes cast, gives political parties a control of the House of Commons. Therefore, they have little incentive to build any consensus or listen to alternative voices. Members of parliament can sign critical motions, but governments ignore them. Many MPs are just voting fodder and rarely vote against their party's position. The potential of select committees to scrutinise government policies is also limited. The composition of select committees is often decided by the party hierarchy and some independent-minded MPs can be kept off such committees. These committees have limited resources and are rarely in a position to initiate legislation.
Without a deeper reform of the political institutions and policies for taming corporate power, a durable and responsive regulatory system cannot be developed and the UK is fated to repeat the past scandals
Raw dealing, P Sikka
The claims of professional ethics may provide a veneer of respectability for major accountancy firms, but their practices reveal the truth.
Accountancy firms are the new masters of the universe shaping audits, accounting, accountability, corporate governance, taxation, insolvency, consultancy, railways, the NHS, Private Finance Initiative (PFI), government departments and much more.
The world of accountancy is dominated by just four secretive accountancy firms: PricewaterhouseCoopers, Deloitte & Touche, Ernst & Young and KPMG, although their might is now being challenged by mid-tier firms such as Grant Thornton. The Big Four's combined global income of $80bn is greater than the gross domestic product of many nation states. They are controlled by secret trusts headquartered in offshore tax havens (Bermuda and Switzerland), which do not have multilateral information sharing treaties with other countries. Despite appealing to codes of ethics, profit-hungry accountancy firms are engaged in a race to the bottom. A few examples would help to illustrate the issues.
In the year 2000, the Italian competition authority fined the then Big Six accountancy firms for operating an illegal cartel. Their secret agreements included fixing prices and deciding in advance the firm that would win any auditing contracts. More recently, the Big Four firms, plus Grant Thornton, got together to challenge the French government over its law barring accountancy firms from auditing a company's accounts if they have provided advisory services to the client in the past two years. The same firms are planning to make further joint challenges to the French law. The UK government has shown no interest in investigating the practices of major firms.
Around the world, some $2.5 trillion is estimated to be laundered each year. An early indication of the involvement of accountants is provided by the UK high court judgment in the case of AGIP (Africa) Limited v Jackson & Others (1990) 1 Ch 265et seq. The judgment noted that:
"Mr Jackson and Mr Griffin are professional men. They obviously knew they were laundering money... It must have been obvious to them that their clients could not afford their activities to see the light of the day.... [They] were introduced to the High Holborn branch of Lloyds Bank Plc in March 1983 by a Mr Humphrey, a partner in the well-known firm of Thornton Baker [this is now part of Grant Thornton]. They probably took over an established arrangement. Thenceforth they provided the payee companies... In each case Mr Jackson and Mr Griffin were the directors and the authorised signatories on the company's account at Lloyds Bank. In the case of the first few companies Mr Humphrey was also a director and authorised signatory. "
Despite the very strong court judgment, there has been no investigation by any UK government department, regulator or professional body.
Tax avoidance is a huge money-spinner for accountancy firms. The US government is estimated to be losing nearly $300bn of tax revenues each year. The US Senate committee on governmental affairs (pdf) investigated the activities of KPMG and after examining the firm's internal documents concluded (page 4 of the report) that the firm:
Quot;... devoted substantial resources to, and obtained significant fees from, developing, marketing, and implementing potentially abusive and illegal tax shelters that US taxpayers might otherwise have been unable, unlikely or unwilling to employ, costing the treasury billions of dollars in lost tax revenues".
The Senate hearings found that to secure competitive advantage senior officials at the firm had decided not to comply with the law requiring them to register avoidance schemes with the tax authorities. One internal document, mentioned on page 13 of the Senate report (pdf), noted that:
Quot;Based upon our analysis of the applicable penalty sections, we conclude that the penalties would be no greater than $14,000 per $100,000 in KPMG fees... For example, our average... deal would result in KPMG fees of $360,000 with a maximum penalty exposure of only $31,000".
Through such strategies KPMG received more than $120m in fees while the US treasury lost billions in tax revenues.
Subsequently, the US department of justice charged (pdf) the firm with criminal conduct. The firm admitted such conduct and paid a fine of $456m. Several KPMG (now ex) partners are facing what the US department of Justice described as "the largest criminal tax case ever filed". In March 2006, one of its ex-partners told a court, "I willfully aided and abetted the evasion of taxes". Other major firms and their partners are also facing lawsuits for selling questionable tax avoidance schemes.
The US methods for selling tax services also appear to be used in the UK. For example, a Tax Tribunal heard (pdf) that KPMG cold-called clients to sell a VAT avoidance scheme. The scheme was found to be unlawful and the firm appealed to the European court of justice, which declared it to be "unacceptable". Accountancy firms continue to sell dubious tax avoidance schemes (pdf). A partner of a mid-tier firm was bold enough to say: "no matter what legislation is in place, the accountants and lawyers will find a way around it. Rules are rules, but rules are meant to be broken". The UK is estimated to be losing between £97bn and £150bn of tax revenues each year. Yet neither the Treasury nor any select committee has launched an investigation into the practices of major firms.
In 2001, the New York district attorney told a US Senate committee that:
Quot;In 1996 my office concluded a case involving the bribery of bank officers in US and foreign banks in connection with sales of emerging markets debt, transactions that earned millions for the corrupt bankers and their co-conspirators. In this case, a private debt trader in Westchester County, New York, formerly a vice president of a major US bank, set up shell companies in Antigua with the help of one of the "big-five" [these are now part of the Big Four firms] accounting firms; employees of the accounting firm served as nominee managers and directors.
The payments arranged by the accounting firm on behalf of the crooked debt trader included bribes paid to a New York banker in the name of a British Virgin Islands company, into a Swiss bank account; bribes to two bankers in Florida in the name of another British Virgin Islands corporation and bribes to a banker in Amsterdam into a numbered Swiss account".
Successive UK governments have failed to commission any independent investigations into the real or alleged audit failures at Polly Peck, Bank of Credit and Commerce International (BCCI), Levitt Group of Companies, The Accident Group, Resort Hotels, or the UK parts of the Enron, WorldCom, Ahold, Parmalat, WestLB, Hollinger and Xerox episodes. In other countries, the regulators are becoming more concerned. The US securities and exchange commission (SEC) fined PricewaterhouseCoopers for persistent violation of auditor independence rules. Ernst and Young (E&Y) were prosecuted for persistent violations of auditor independence rules.
In April 2004, a 69 page court judgment (pdf) stated: "EY committed repeated violation of the auditor independence standards by conduct that was reckless, highly unreasonable and negligent... They were committed by professionals throughout the firm, who exhibited no caution or concern for rules on auditor independence in connection with business relationships with an audit client... EY partners acted recklessly and negligently in committing wilful and deliberate violations of well-established rules... "
The firm was banned for six months from securing any new audit clients and put on probation for three years.
In another case, a US judge banned a Deloitte & Touche partner for life for audit failures at Adelphia. The judge ruled that among other things the audit partner bowed to pressure from the company, which didn't want to disclose the full amount of money it co-borrowed with businesses owned by its founders.
In September 2005, four accountants at the Japanese firm ChuoAoyama PricewaterhouseCoopers were arrested for allegedly helping Kanebo executives falsify accounting reports and conceal losses of nearly £1bn. After further investigations the Japanese regulators suspended the firm's statutory auditing operations for two months. This effectively haemorrhaged the firm's operations. It subsequently reinvented itself by forming another organisation.
The above is only part of the mounting evidence that raises concerns about the activities of major accountancy firms and highlights the need for UK regulators to intervene.
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