Time’s up for the Big Four

In July, only a few months later, Carillion’s rosy financial outlook had been utterly transformed. The company issued an £845 million profits warning, the largest the City had seen in a generation, wiping out combined profits since 2012. And by the turn of the year, despite another £1.9 billion of government contracts, Carillion had imploded – forced into compulsory liquidation.

The Official Receiver found Carillion had a staggering £6.9 billion of gross liabilities. Some 30,000 suppliers and sub-contractors, many of them small and medium-sized firms, are now shouldering £1.2 billion in unpaid bills. Carillion’s £800 million-plus pension deficit is the largest ever to be absorbed by the Pension Protection Fund, to be subsidised by levies on other workplace pension schemes.

The accounts published in April 2017 that unravelled so quickly were overseen by KPMG – Carillion’s external auditor for the entire 19 years of the construction firm’s existence.

The Carillion meltdown follows recent audit controversies involving Tesco and the software company Quindell, among others, similarly relating to profit over-statement and “aggressive accounting”. It’s not just a UK phenomenon. The International Forum of Independent Audit Regulators found that no less than 40% of the audits it inspected last year around the world were sub-standard. All those with serious deficiencies were by KPMG, PwC, EY or Deloitte. These ‘Big Four’ auditors generated combined global revenues of $134 billion last year, directly employing 945,000 people.

They are now under fire in many countries – having been involved in tawdry episodes from the Petrobras scandal in Brazil to the Gupta affair in South Africa. Auditing is in crisis and must be reformed. And the UK, as the world’s financial services superpower, needs to take the lead.

Previous changes to accounting standards, following earlier scandals, mean big auditors are now just box-tickers, able to avoid nuanced judgement. Conflicts of interest remain endemic, between firms, their clients and regulators. Even in advanced country jurisdictions, regulatory oversight is weak and feebly enforced. That’s because the Big Four have been allowed to establish themselves as a hugely powerful, practically untouchable oligopoly – auditing an astonishing 97% of FTSE 350 UK-listed companies and 99% of S&P-500 in the US.

The auditing profession – with its too-big-to-fail and increasingly too-big-to-regulate structure – is at the heart of our crony capitalist crisis. Reforming audit sounds obscure, but is a vital part of re-building public confidence in Western liberal capitalism.

Listed companies must employ auditors by law. With four companies so overwhelmingly dominant, the resulting lack of competition promotes malpractice. Since the Enron scandal, and the demise of Arthur Andersen – the fifth member of what was, until 2002, the Big Five – the authorities have been petrified of heavily sanctioning the rest, fearing an even more dominant Big Three. This explains the regulators’ light touch approach – and why, after the systemic misreporting ahead of the 2008 financial crisis, the Big Four faced so little sanction.

The current audit industry structure seriously undermines the public interest. The Big Four are too profit-driven and compliant towards the managers of client firms, resulting in low-quality reporting – a disservice to investors, tax authorities and the broader public. “It is crazy there are just four top-bracket auditors,” Sir John Bourn, the UK’s longest ever serving Auditor General, told me. “The system simply doesn’t work and hasn’t for a very long time”.

During the decade before Carillion collapsed, the Big Four received a combined £51 million to advise and assist the company. They all deny wrongdoing and say they acted in good faith. Yet after a Parliamentary report said the Big Four were a “cosy club incapable of providing the required degree of independent challenge”, the Financial Reporting Council, the UK’s main official corporate government watchdog, is now investigating KPMG’s work at Carillion.

Carillion has become a byword for financial misreporting, and public anger towards the profession has been further fuelled by revelations that Big Four firms working at Carillion got their bills paid before the company went bust, in contrast to thousands of regular contractors. And, of course, with the Official Receiver now overseeing Carillion, some of the very large audit firms are being paid large amounts of public money to dismantle the debt-soaked mess.

A complete overhaul is needed – here are five reforms to fix the industry.

1. Tackling Market Structure

An investigation by the UK Competition Commission resulted in the introduction of a nominally stricter audit industry regime in 2013. But the proposals were piecemeal and, after extensive auditor lobbying, heavily diluted. They have almost entirely failed – and in some cases been counter-productive.

Mandatory auditor rotation was recently introduced – but only every 20 years. Since then, the industry has become even more concentrated. In 2013, the Big Four audited all but 16 of of the UK’s 350 largest listed companies. Last year, it was all but nine.

In March, Britain’s fifth-biggest auditor, Grant Thornton, announced it would no longer tender for audits of FTSE-350 companies, complaining the grip of the top players remained so strong with its network of alumni in the Finance Departments of listed firms, that retendered contracts were all kept within the Big Four.

The time for tinkering is over. The Competition and Markets Authority – the successor to the Competition Commission – must urgently re-investigate the audit industry, with a view to breaking up the leading players. Only a wholesale, forced restructuring will spread highly experienced and influential individuals across a larger number of firms, so generating more competition.

2. A Cap on Market Share

The Financial Reporting Council (FRC) has singularly failed to tackle lax auditing. But rather than being disbanded, it should be strengthened, with its mandate extended to implementing a cap on market share. The Big Four should be required to reduce its combined coverage from 97% to 60% of FTSE-350 firms over the next five years, then 40% over ten.

‘Shared audits’ would count towards that reduction in market share, but only for a five-year period at each listed company, and only as long as Big Four companies gave smaller rivals access to their technology platforms.

Rotation is also crucial – not just re-tendering, but a change of auditor. This should happen every five years, rather than every 20 years as at present.

3. Separate Audit and Consulting

As well as market share, it is vital to address conflicts of interest. The Big Four provide extensive and highly lucrative consulting services to the same group of companies they audit – generating two-thirds to three-quarters of their fees from consulting. After Enron collapsed, under US regulatory pressure, three of the Big Four split from their consulting arms, but they have since rebuilt that part of their business.

There are widespread fears independent audit work is compromised by the prospect of securing large consulting contracts from the same clients. And with senior staff at the Big Four increasingly focused on consulting, ever more complex audit work is pushed onto junior, less-experienced staff.

Auditors should be forced to divest their consulting arms, with regulators being granted powers to insist on ‘audit-only’ firms. The FRC previously opposed this idea. Since the Carillion collapse, the watchdog has said such a move should “be considered”.

4. More Active Investors and Listing Authorities

Investors must be more demanding of audits. There are signs this is happening. Standard Life Aberdeen, one of the UK’s largest institutional investors, recently publicly stated that the “Big Four let profits affect audit views”. The company has held meetings with the boards of FTSE-100 and FTSE-250 companies, trying to convince them to appoint auditors outside the Big Four.

Should it be listed companies that choose who audits them, or shareholders and other investors? If auditors were hired by shareholders they could be robust, judging governance and even management quality without fear of losing clients.

The idea of auditors working for stock exchanges and other listing authorities should also be explored. Any companies wanting to list its shares on an exchange would be scrutinised by that exchange’s appointed auditor, with audit costs included in the price of listing. The exchange could employ a range of auditors, rotating them at will. It could even offer lower audit fees to companies found to have the best internal controls and standards, incentivising good behaviour and recognising that they will cost less to audit anyway.

5. Less Complex Rules – Back to First Principles

“If you look at the rules for the preparation and auditing of financial statements, you are overwhelmed by their size and complexity,” says Former UK Auditor General Sir John Bourn. “This complexity is really getting in the way of proper audit and genuine transparency – and sometimes, out of that complexity, you get deliberate obfuscation”.

Over recent decades, rather than holding themselves and clients to the highest standards, the Big Four have introduced overly complicated disclosures and procedures. As such, ‘tick box’ formulas have been used, rather than principled rules, to help large clients get away with ‘aggressive accounting’ to mutual benefit, with leading auditors using their enormous influence to avoid liability.

They’ve been helped not only by ever more complex rules, but also a gradual move away from historical cost accounting and towards the notion that accounts should present information that is “useful to users”. As such, company managers have been able to bring forward anticipated profits and unrealised gains, presenting them as current surpluses. Such practices are widely seen to have taken place at Carillion – where ever increasing reported profits drove a rising share price, along with dividends and executive bonuses, even amidst negative net cash. That’s why Sir John Bourn later described Carillion as “a Ponzi scheme”.

UK company law says accounts must present a “true and fair value” of the underlying business. It strikes me there is a tension between such company law based on “factual verification” and rules introduced stealthily over many years, relating to “useful to users” principles, that rely instead on “faithful representation”. This gradual rule change has been deeply damaging – a gateway to abuse. It should be entirely reversed.

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The Big Four constitute a formidable lobby. Across the UK, Europe and the world, many audit professionals are doing very well for themselves and want things to stay as there are. I’m often told I don’t know what I’m talking about and the situation is too complex for me to understand.

Well, as an economist, who also covers politics for living, what I do know is that the auditing profession, as it is currently conducting itself, is helping to provoke rising popular discontent with capitalism. This is an extremely dangerous trend and must urgently be reversed.

The Big Four deny wrongdoing, insist they acted in good faith and, are appalled by the idea they could be broken up. They claim auditing is a unique market requiring companies of huge scale due to global demands and say that forced restructuring would be unduly disruptive.

But there are plenty of international law firms, competing vigorously for business. And, while the break-up of Standard Oil, AT&T and other highly dominant companies throughout history has been disruptive, this restructuring sparked more competition, encouraging broader innovation and investment and ultimately adding to national wealth and the public good.

The reform of audit should begin in the UK. London is the hub for the world’s largest firms, the policy debate here has been on-going over many years. Catalysed by Carillion, there is now a growing clamour for change among politicians, regulators, and the industry itself – albeit largely outside the Big Four.

So the threat of a major restructuring should now be placed on the table. And if the Big Four want to avoid that outcome, they must accept market caps, compulsory rotation and other new measures, demonstrating a very clear and immediate determination to reform – in the interests of themselves and the broader public.

 

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