Hidden In Plain Sight: Audit Failure And The Big 4 Audit Firm Response

Significant criticism of the global audit firms and their poor performance before, during, and after the financial crisis of 2008-2009 is hidden in plain sight.  Recent reports from the UK Audit Inspection Unit (AIU under the FRC) and the US PCAOB (under the SEC) highlight several very serious issues that should force regulators and legislators to act on wholesale reforms and sanctions against firms and individuals.

More importantly, these criticisms – that auditors failed to follow professional standards, were insufficiently skeptical of managements’ assumptions, and did not obtain sufficient evidence for their audit opinions – should first and foremost make investors furious.  Where is the outrage when government sponsored guardians of shareholder interests have failed the public so miserably?

Today I’m going to summarize some of the findings by the UK regulator and the firms’ response to these findings. The rhetoric is at a much higher pitch and the firms are being pushed by journalists and politicians much more in the UK than in the US.

Tomorrow I will summarize the PCAOB’s findings in light of subsequent bank and financial institutions failures, bailouts, and litigation.

Accountancy Age has written several stories about the findings of the UK AIU:

On PwC:

On the majority of work reviewed by the Audit Inspection Unit, PwC auditors did not identify revenue recognition as a significant risk, a move the watchdog said was ” inconsistent with Auditing Standards.”

“More needs to be done by the firm to change the behaviour of audit teams 
and to encourage them to exercise greater scepticism in this area,” the AIU said. However PwC shot down any suggestion that there was an issue with the firm being too easy on clients.

On selling non-audit services to audit clients:

The controversial practice of selling non-audit services to audit clients is frowned upon by authorities and expressly forbidden from being taken into account during staff appraisals, however audit inspections have found the practice survives and, in some cases, auditors want to be rewarded for it…an audit industry under pressure, with partners pushed to pull in the pounds and eager to show off how much money they brought in…a picture of on an industry under financial pressure and concentrating on boosting its bottom line.

Deloitte’s audit directors and managers referred to cross-selling when trying to secure promotions, according to the AIU. At Ernst & Young, the AIU found some staff had attached their personal sales data in their annual appraisal.

On audit quality at PwC:

PricewaterhouseCoopers changed its bonus criteria to emphasise business growth, which jumped from 25% to 40% as a proportion of its KPIs. Meanwhile, audit quality portion dropped from 25% to 20%.

The FRC’s audit inspection unit, which investigated the issue, said the underlying message represented “a potential risk to audit quality”…PwC staff were told to reduce audit hours by 5%.

However, 35% of PwC staff signing off audit reports are audit directors, with the remainder being audit partners. This proportion has increased in recent years and compares with 25% in 2006, the AIU said. This comes in the context of PwC identifying in its internal review that quality was less consistent on those audits where the engagement leader was an audit director, compared with audits led by partners.

On independence standards and EY:

An Ernst & Young (E&Y) partner was earmarked for the directorship of a client-company while also providing independent advice about its IPO…one of a number of issues identified in the annual Audit Inspection Unit (AIU) report into the firm.

According to the report, a transaction advisory services partner, who was due 
to retire from the firm, acted as a prospective director of a client which undertook an IPO. Ethical standards prohibit a partner from accepting an appointment to the board of
directors of a client.

On sufficient audit evidence and KPMG:

The AIU found deficiencies in audit evidence obtained by the firm, including attendance at stock-takes where the value of stock had been identified as a significant risk…On three occasions the auditor’s report was signed off prior to completion of all necessary work, an area previously flagged up by the AIU previously…Other issues included not contacting banks or custodians to obtain audit evidence supporting the existence of assets or liabilities – alternative evidence was obtained and the main reason given for not contacting the banks was stated to be the difficulty in obtaining reliable responses.

On goodwill and non-partners signing audit reports at Deloitte:

The AIU found an error in the goodwill testing model, with the implications meaning an overstatement of the available financial “headroom”. In another inspected audit, the Deloitte team gave “insufficient” consideration to a major customer announcing a credit squeeze. The AIU identified various areas for Deloitte to improve its auditing services, including evaluation of controls over significant risks and communicating with audit committees…Other findings in the report include 26 non partners at Deloitte are authorised to sign off audit reports in addition to the 184 UK audit partners.

The firms have responded to these criticisms with a combination of carrots and sticks.

Deloitte has gone on the charm offensive, moving its global headquarters to the UK and announcing it will hire hundreds and thousands of people over the next five years.   They’ve self-declared as the #1 firm in the world, replacing PwC. At the same time, their Chairman has rebutted any possibility that anyone would ever think, even remotely, in the far reaches of a fantasy world based on delusion, there was any problem whatsoever, refuting any suggestion that audit quality isn’t the best now that it ever was.

Accountancy Age, September 24, 2010:

The audit market is “fiercely competitive and transparent” according to Big Four firm Deloitte, which sees no reason to open the top-heavy industry to greater competition.

Deloitte believes audit quality is “higher than ever” and said it has seen “no evidence of anti-competitive behaviour”, according to its submission to the upcoming House of Lords inquiry into audit competition.

PwC’s answer to criticism is a new global brand image.  I think that just about says it all.  If you have any doubts about where their priorities lie, take a look at the video.

PwC’s US Leader Robert Moritz: “The change that we’re talking about is all about exemplifying the PwC experience. Building relationships. Enhancing value.”

In the UK, PwC’s top auditor Sexton says it’s all in the timing:

“While we are fully committed to taking action to address your findings, the timing of your work means that often the audits that you review have been completed before our receipt of the prior year’s AIU report.

“As a result, it can sometimes be the case that the impact of the actions that we 
take are not measureable until the next but one inspection. As such, the repetition of findings in two consecutive reports should not be construed as us failing to act upon findings – it may be a matter of timing.”

A KPMG anonymous firm spokesman responded to the AIU in the same snarky way the firms often make their point in the US:

KPMG said it had already taken appropriate action to address the specific matters raised.

“Whilst we may not always have exactly the same view as the AIU on the significance of individual matters, we share the objective of avoiding ‘any significant improvements required’ in assessments in future,” the firm said.

KPMG is also flashing the “We’re hiring so don’t piss us off” card in the UK and Europe.

From The Financial Times, October 4, 2010:

KPMG is hiring 8,000 new staff across Europe over the next three years, signaling a recovery in the corporate services industry. The hiring includes 3,000 staff in Britain, even though the UK government has pledged to cut its consultancy bill amid growing public unease over the billions of pounds spent on professional fees in the past decade. The recruitment drive will take KPMG’s workforce from 30,000 to 38,000 across Europe, excluding France and Italy, and from 11,000 to 14,000 in the UK. KPMG also has ambitious hiring plans in France and Italy.

I’m most incredulous at Ernst & Young’s response to the tons of criticism heaped on their firm, in particular with regard to Lehman.  In the UK, frustration with EY is also strongly focused on their failure at Anglo Irish, a multi-billion dollar bailout. Chairman Jim Turley has now given an exclusive interview to Fortune’s Geoff Colvin, after several months of radio silence following the necessary but insufficient knee-jerk response to Lehman via letters to Audit Committee members.

More about this interview and the rest of the video segments in a later post specifically on Lehman and EY.  But it’s worthwhile to note Turley’s response at the 3:25 mark to Colvin’s softball question: “Was the crisis caused by some financial firms doing misleading things that were within the rules?”

Turley corrects Colvin, even given his extremely diplomatic tone, and runs out the clock: “I don’t think it’s fair to say there were misleading things. At the end of the day, a lot of poor business decisions came home to roost.”

Well…there you have it.

Main page image by Jenny Holzer, London 2006 projection.