How the UK is trying to prevent accounting scandals

Regulators to the rescue.
Regulators to the rescue.
Image: REUTERS/Toby Melville
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It’s not every day that accounting firms are called on the carpet by national lawmakers or that the auditing industry becomes national news. It’s happening in the UK.

“I wonder? How many more company failures and how many egregious cases of accounting do we need?” said Rachel Reeves, a committee chair in the UK’s House of Commons. She was blasting representatives of PricewaterhouseCoopers and Ernst & Young, at an October hearing investigating the sudden collapse of travel company Thomas Cook, which both firms had audited.

As Reeves’ comments suggest, the UK is in the midst of a big push toward revamping its accounting industry. The UK industry faces many of the same problems as its US counterpart, like struggles with audit quality and conflicts of interest that stem from consulting, but a series of high-profile accounting failures at British companies have brought the industry’s woes to the fore.

Among other measures, UK regulators and government officials are considering a drastic step: Should the firms be broken up, to split their audit and consulting businesses?

“You cannot get rid of those conflicts of interest unless you have a separation of the audit and the non-audit part of the business,” Reeves told the firms. Tougher regulation is needed, she said, or “we will have more business failures and you will be complicit in those.”

The firms say they recognize reforms are needed, but they don’t think separating auditing from consulting will help. Such a move would be “an untested experiment” that could hurt audit quality, place new burdens on UK businesses, and weaken the UK’s competitiveness, said Stephen Griggs, the managing partner for Deloitte’s UK audit business.

The UK woes spotlight the fact that the problems the accounting industry faces go far beyond the set of damaging scandals that US KPMG has endured in South Africa. Major corporate accounting scandals have popped up in countries from Malaysia to Japan to Brazil. In China, investors have no way of knowing whether audit firms are doing their job properly, because the Chinese government doesn’t allow US regulators to inspect their work.

In the UK, the recent corporate and audit failures became “kind of the final straw that broke the camel’s back,” said Prem Sikka, an emeritus professor of accounting at the University of Essex. “I think public opinion over a long period has been sensitized.”

These problems may be happening far from the US, but they could come back to haunt US investors. Overseas audit firms whose work has come into question or is unverifiable help audit giant US companies like Citigroup, Starbucks, and Johnson & Johnson.

The UK uproar was triggered when companies like construction company Carillion abruptly went bust without any warning from their auditors that anything was amiss. All of the Big Four were involved with Carillion: KPMG was its outside auditor, Deloitte handled its internal audit, EY advised Carillion on its finances, and PwC advised Carillion’s pension trustees before the company collapsed, and assisted in its liquidation.

European Union rules prohibit UK audit firms from providing some types of non-audit work to their audit clients, akin to the Sarbanes-Oxley Act’s restrictions on U.S. firms. But the EU limits have been in effect only since 2016—and, as in the US, UK officials are still concerned that the opportunity to profit from providing often-lucrative consulting services might prompt the firms to go easy on their audit clients.

EY, Thomas Cook’s auditor when it collapsed in September, made 23% of its 2018 fees from the company from non-audit services, according to Thomas Cook’s annual report. (EY says the services it provided had to be done by the company’s auditor, even though they aren’t officially considered part of the audit.) PwC both audited Thomas Cook until 2016 and provided advice for the company’s executives on their compensation until 2009. (PwC has said its work was allowed, properly disclosed, and approved by the company’s audit committee.)

The UK had “a very complacent audit culture” in the past, with weak regulation and no major punishments for auditors when things went wrong, said Atul Shah, a lecturer at City University of London. Now “this has been much more in the public eye.”

Breaking up the firms is “a potential solution,” said Mark O’Connor, CEO of Monadnock Research, a Massachusetts firm specializing in consulting-industry research. “It’s the only way it’s going to happen, because the firms aren’t going to do it themselves.”

But John Boulton of the Institute of Chartered Accountants in England and Wales, a UK accounting-industry group, doesn’t support a separation of the firms. “I don’t think that’s necessarily where the most productive focus can be.”

Griggs said “audit quality is considerably enhanced” when auditing and consulting are part of the same firm, giving auditors access to specialist expertise and investments that come with consulting.

“We don’t believe breaking up firms will improve audit quality,” PwC’s UK affiliate said in a statement. Changes are needed, the firm said, “but no one wants to see measures that fail to deliver the intended benefits.”

In addition, the UK is also planning or considering steps like separating auditing from the broader accounting profession; having auditors do more to detect fraud; replacing its current audit regulator, the Financial Reporting Council, with a new, more powerful body; and requiring large companies to conduct joint audits, using both a Big Four audit firm and a smaller firm.

The industry’s problems aren’t limited to the US and UK. The “Lux Leaks” scandal reported by the International Consortium of Investigative Journalists found that PwC had helped multinational companies get favorable tax treatment in Luxembourg.

KPMG has been slammed by scandals in South Africa over its ties to the politically connected Gupta family and a KPMG report on the nation’s tax agency whose findings the firm later had to retract. (KPMG South Africa says it has made significant changes in response to the scandals and is “confident that we are on the right path.”) Deloitte has come under fire over its role in auditing Malaysia’s 1Malaysia Development Berhad, or 1MDB; it was fined in January 2019 by Malaysia’s securities regulator.

One thing that may aggravate these problems is the Big Four firms’ unusual global structure. They aren’t corporations, or regular partnerships. They’re networks comprised of member firms in each country—affiliates which are legally separate from and have no obligation to each other.

An international umbrella organization sits at the top of each network, setting overall strategy and promoting the brand, but the local firms generally operate independently. It’s a little like a fast-food chain: local franchises are all part of the same company, but each goes its own way.

The effect is to insulate each country’s firm from any legal liability for the actions of its siblings elsewhere. If KPMG has a scandal in South Africa, KPMG’s US partners can’t be held liable. The decentralized structure also makes it hard for a Big Four network’s top international officials to crack down on any bad-apple local firms.

Critics say that means the Big Four have no real incentive or ability to prevent wrongdoing by wayward affiliates. “They use the Big Four name to advertise worldwide,” said Steven W. Thomas, a plaintiff’s attorney who specializes in lawsuits against accounting firms. “But then, soon as there’s a problem, they say no, we’re not the same firm.”