It is time to audit our auditors; Investors can only trust capital markets if they trust their auditors; Big Four earn annual audit fees of US$10 billion in US

April 16, 2013 7:30 pm

It is time to audit our auditors

By Anthony Catanach

Investors can only trust capital markets if they trust their auditors, writes Anthony Catanach

The revelation that a partner at KPMGleaked privileged information to a “golfing buddy” for a few silver coins is not just another accounting scandal. A 29-year veteran of the accounting firm provided advance notices of client earnings releases and merger plans in exchange for more than $50,000 in cash and gifts, including a $12,000 Rolex watch. It would be easy to dismiss this event, given its minor monetary consequences relative to some of the auditing blunders of the past decade. But this event just may be a watershed.

Investors can view today’s global capital markets as secure only if they trust the financial statements issued by publicly traded companies. Fundamental to this is the belief that information provided by market participants is accurate, complete, and reliable. Accountants have been given the task of certifying this. Investors must, therefore, trust that public company auditors are not only knowledgeable and experienced, but also independent and possess the highest levels of integrity.

There is already mistrust of the profession. The auditors who allowed Enron to flatter their balance sheets have not been forgotten. Nor those who signed off on the infamous Lehman Brothers “Repo 105” accounting wheeze, which magically transformed loans into sales. Such cases cause one to wonder if our current levels of trust in the auditing profession may be too high. What makes the KPMG case so important is that it involves a senior partner with authority over 50 other partners and more than 500 staff in one of the firm’s largest offices. He placed his own self-interest before that of his clients, much less the investing public. As a result, KPMG has withdrawn several years of audit reports for some clients. This is quite a moment: it is the first significant withdrawal of an audit report since 2007, when PwC did the same for Yukos, the bankrupt oil company, over concerns about the accuracy of information provided to the auditor by the management.Auditors rarely withdraw from an engagement. Audit Analytics, a service that tracks reports on publicly traded US companies, reports 12 resignations during 2013 thus far, but only 26 during 2012 and 33 in 2011. Of these resignations, with the exception of the recent KPMG debacle, not one was related to so-called “independence” issues – conflicts of interest – in 2013. There was only one independence-related resignation in 2012 and six in 2011. So, actually, to have a major accounting firm admit not only to discovering a breach of auditing standards but then to withdraw its previously issued audit reports, is indeed rare.

Given the extraordinary nature of KPMG’s recent breach, how it came to pass and its consequences, we should be scrutinising this event carefully. Some parties are using this recent partner’s inappropriate behaviour to push for regulations requiring the naming of auditors, or the periodic rotation of audit firms. It should however be noted that neither of these “fixes” would have detected or prevented this partner’s disregard of basic auditing standards.

Clearly, internal controls in the audit process are not working at KPMG and other large accounting firms. With increasingly constrained resources, increased governmental oversight is not likely to solve the audit quality problem either. We simply need more transparency from these firms upon whom we rely to protect our interests.

Just as investors require reports to make informed decisions, so do we need information to better assess auditor competence, integrity and quality. I would suggest that any accounting firm that audits a traded company be required to provide an annual report, which would include certifications for financial statements and internal control systems.

For those who may argue that I am overreacting to this “outlier” event, I would remind them that the audit itself is based on trust. As William O. Douglas said: “Sunlight is the best disinfectant.” Sunlight may be exactly what we need to restore our trust.

The writer is an accounting professor at Villanova University and Maguire fellow at the American College

April 16, 2013, 12:30 p.m. ET

Auditors Should Open the Books

By HELEN THOMAS

Number crunchers need to open up.

For a profession intimately involved in providing information, auditors are an uncommunicative bunch. Accountants’ work is condensed into an anodyne, one-page report, telling investors virtually nothing they didn’t already know. The pass/fail system—stating whether financial statements are fairly presented—offers no insight into judgments or concerns, or crucially where accountants and managers disagreed. Audits have been impenetrable black boxes for too long.

Revelations last week that a KPMG audit partner passed stock tips to a friend are embarrassing for the industry but have also refocused attention on auditors and what they produce. That said, it was the financial crisis that provided the real impetus for change.

Pension fund Calpers, in postcrisis discussions with the U.S. Public Company Accounting Oversight Board, pointed to a bank that received government bailout funds, noting that—while audit fees increased by 60%—the missive to investors from 2008 to 2010 remained identical.

In the U.K., KPMG faces a possible inquiry into its examination of HBOS over what appears to be egregious underprovisioning for loan losses before the bank’s collapse. The U.K.’s financial regulator last year suggested that the firm had urged a more-prudent approach in the face of management’s sunny optimism. Investors, however, were left in the dark.

Changes are under way, but moving at far too slow and uncertain a pace. In Europe, proposals have veered into ludicrous levels of prescription, suggesting a report of no more than 10,000 characters but requesting the names of the entire audit team. The PCAOB two years ago floated alternatives, including an Auditor’s Discussion and Analysis of significant issues, with its chairman last month arguing that a different form of report could “redirect the auditor’s mind-set from meeting minimum criteria to identifying key insights…that will help a user understand the quality of financial reporting.”

Thus far, the U.K. has backed additional disclosure from board audit committees and is considering introducing a discussion of risks into the report itself. More insipid boilerplate or reams of meaningless information help no one. The hope is that additional commentary becomes a yardstick upon which boards and investors can judge audit quality.

Central to the debate is who should keep shareholders informed of audit issues: the board or the number crunchers. The easy answer: both. Investors want to hear from the accountants regarding the nitty-gritty of their work. The board can rightly add their view of the issues, as well as explaining steps taken to ensure a robust and independent process. Litigation is one concern, particularly in the U.S., where accountants fear more disclosure will lay them open to lawsuits while some worry that a more discursive style will let firms wriggle off the legal hook.

The profession may agonize over whether auditors should potentially convey information not yet released by a company. But a determination that investors are better served through less information would be perverse.

Auditors are employed by boards on behalf of investors. More expansive audit reports should reflect that fact.