Fraud Symptom 12 – Unethical Compromises by External Auditors

In the recent corporate frauds, auditors’ professional robes were soaked in dirty money. Their unblemished reputations tarnished, they dealt with allegations of compromising ethics, code of conduct and reporting responsibilities for self-interest and business opportunities. Auditors, the bastions of corporate governance and maintaining shareholders interests miserably failed in performing their duties. In some cases they failed to detect the frauds, and in others they collaborated with clients to facilitate them in conducting frauds.

The contract clauses of reasonable assurance, limited liability and others lets them escape criminal liabilities usually. The regulators, shareholders, employees, third parties and the public helplessly watch the organization going bankrupt and/or closing down because auditors failed to detect wrong doing or failed to report the same. The financial crises showed that without due care, global economies go in recession. That should make auditors more responsible; however, it is not the case.

Francine McKenna author of blog re: The auditors  is a pro in digging dirt about big four and openly shares her views. This extract from her blog shows the interrelationships between big four and corporate giants. With these relationships independence of external auditors is easily questionable and suspect frequent compromises. Though I normally don’t post big extracts from other blogs, this one is too good to miss.

“KPMG audits Citigroup, Wells Fargo – who now owns client Wachovia – GE, and GM.  They used to audit two big mortgage originators before they blew up – Countrywide and New Century. They also used to audit Fannie Mae and Moody’s before they were fired and sued. They also audit the US Treasury.

PricewaterhouseCoopers audits JP Morgan Chase, Bank of America, Goldman Sachs, AIG, the Federal Home Loan Banks, and Freddie Mac. PwC is also responsible for Satyam, Northern Rock in the UK, Glitnir in Iceland, and Russia’s Yukos.

Deloitte, who is now Fannie Mae’s auditor, was also auditor of four other housing related companies that had issues: Taylor Bean & Whitaker, Beazer, Novastar, and American Home. (The bank that TBW bankrupted, Colonial Bank was audited by PwC.) Deloitte audited three no-longer-independent large firms sunk by bad mortgages: Merrill Lynch, Bear Stearns, and Royal Bank of Scotland. Deloitte used to audit Washington Mutual before it was taken over forcibly by JP Morgan. They also audit the Federal Reserve Bank and Buffett’s Berkshire Hathaway.

Ernst & Young, everyone knows, audited Lehman Brothers. But don’t forget UBS and Societe Generale, home of the “rogue” traders, and Anglo Irish in Ireland. EY also audits News Corp and S&P, the ratings agency.”

The issue is can shareholders expect auditors to report independently and forgo lucrative business to adhere to ethical standards. Audit organizations need an organization culture that focuses on social responsibility with profit motive. However, some successful ones have a competitive aggressive culture that fails to build in the ethical aspects of auditing.

Therefore, the cultural climate in auditing firms raises questions. The research  paper “Public Accountants’ Perceptions of Ethical Work Climate” authored by Howard Buchan  evaluates Ethical Climate Questionnaire developed by Victor & Cullen for public accountant firms. The following questions were asked from partners to staff to assess the instrumental climate.:

  • “E1 In this Firm, people protect their own interests above all else._____
  • E2 In this Firm, people are mostly out for themselves._____
  • E3 There is no room for one’s own personal morals or ethics in this Firm._____
  • E4 People are expected to do anything to further the Firm’s interests, regardless of the consequences._____
  • E5 People here are concerned with the Firm’s interests-to the exclusion of all else._____
  • E6 Work is considered substandard only when it hurts the Firm’s interests._____
  • E7 The major responsibility of people in the Firm is to control costs._____”

The instrumental climate emphasizes individual self-interest and company interests above all others. Though the study mentions that participants didn’t perceive an instrumental climate, the mean responses ranged from between “mostly false” to “somewhat false”. The results indicate that partners and junior staff perceive ethical climate differently in the firms. Hence, more focus is required on building an ethical culture within the auditing firms

Moreover, though audit firms have been asked by regulators to segregate non-audit and consulting practices, the  bifurcation is cosmetic and not in spirit. A recent example is of PWC India whose partners were implicated in the Satyam fraud.  Times of India reported the insurance claim by PWC for Satyam fraud is fraught with irregularities and arms length distance was not maintained between various PWC entities as required by Institute of Chartered Accountants of India (ICAI).

Price Waterhouse (PW) Bangalore, the tainted auditor of scam-hit Satyam, utilized over 95% of a $60-million (Rs 280 crore approximately) insurance cover available to all Price Waterhouse entities in India to meet post-fraud litigation expenses and damages without paying a single rupee towards the premium. The revelation raises questions about the arguments put forth by the global financial services company that each of its Indian firms is a separate legal entity and not responsible for the acts or omissions of any other member firm. 

PW Bangalore, which had the mandate for the Satyam audit before the fraud came to light in 2009, did not contribute any money towards the Professional Indemnity Insurance (PII) of $60 million, but surprisingly enjoyed the cover when it faced trouble and litigation for the lax audit, documents accessed by TOI showed. PW Bangalore even used the cover to pay $15.5 million towards settlement of a class-action suit filed against it in the US. Till financial year 2011, various entities of PricewaterhouseCoopers India (PwC India)-including a private limited company which renders only non-audit related services-had a common insurance cover. “

The blame for the malpractices has to be shared by regulators, board of directors and shareholders. Most of the fortune 500 companies select big four as auditors. Though audit committees are required to annually review and recommend auditors, in most cases the auditors are not changed. In my previous post on audit committees, I had mentioned this data from Economic Times article – “Can the big four survive a break-up attempt”.

  • In top 100 (US) companies, the average tenure of audit firms was 28 years. 20 companies had the same audit firm for 50 years or more.
  • 85% of the companies in EU are audited by big four.
  • 99% of the audit fees paid by FTSE 100 (UK) in 2010 were earned by big four.
  • Just 2.3% of FTSE firms changed their auditor between 2002 and 2010.

Without regulators taking their responsibilities seriously the audit firms aren’t going to change. For instance, ICAI disciplinary committee for chartered accountants have big four partners as members. In other committees also, big four partners have an influential position. Considering this, it is not surprising that the disciplinary process is slow, as was in the case of Satyam.

Recommendations

1. Regulators must lobby for laws to mandate audit firms rotations. For instance, the new Companies Bill 2011 (India)  requires rotation of audit firm every 5 years and audit partner every 3 years. It also states that no audit firm will audit a company for more than 10 years. These laws will ensure some level of independence and also give a growth option to other audit firms.

2. ICAI and other institutes granting permission for practice to audit firms may periodically conduct an assessment to evaluate the ethical climate of the firm.

3. ICAI and other institutes should either segregate disciplinary responsibilities to another organization or become proactive in disciplining errant chartered accountants.

4. Audit committees, boards and shareholders must proactively manage the appointment of audit firms and evaluate the financial reporting systems.

5. Audit firms should take a leaf out of their own book and focus on building a benevolent organization culture to balance their social responsibility with profit earning objectives.

References:

  1. re: The Auditors by Francine McKenna
  2. PwC arm’s insurance cover under cloud – Times of India 29 February 2012
  3. Public Accountants’ Perceptions of Ethical Work Climate: An Exploratory Study of the Difference Between Partners and Employees within the Instrumental Dimension by Howard Buchan

If you wish to read the Fraud Symptoms series, click here.

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