Those who extol the virtues of U.S. capital markets are quick to tout their transparency. In this case, it is sadly and needlessly lacking.
— David Reilly, Heard on the Street, Wall Street Journal, April 9, 2013

In making this statement, Mr. Reilly was referring to the paucity of information which investors and markets have regarding the accounting firm partners responsible for auditing today’s large global companies.  In “Looking for KPMG’s Mystery Man” he discusses several benefits of disclosing the name of the engagement partner which may improve audit quality.  But while knowing who the responsible partner is would be interesting, many would agree that this information alone probably wouldn’t have prevented KPMG’s recent independence fiasco.  This grumpy old accountant would like much, much more information about the large accounting firms who are supposed to be the “gatekeepers” of the public securities markets.

After half a century of blown audits (that’s as far back as this old bean counter can remember), these firms and their partners have somehow garnered “too few to fail status,” and continue to disappoint us.  And as Michael Rapoport reports, these firms have given us such accounting highlights as the financial crisis of 2007, and just last year, a Deloitte partner’s insider trading.  And now we have a 29-year, life-long KPMG audit veteran, with responsibilities for more than 50 other audit partners and over 500 employees, caught accepting envelops of cash for passing along privileged information.  And David Reilly’s call for more transparency (opening quote), prompts one major question…what do we really know about these firms who are supposed to be protecting the investing public?

Who are the Big Four and how did they become so powerful?  It’s been almost 30 years since Mark Stevens gave us a glimpse of these firms in The Big Eight and The Accounting Wars, so we really don’t know what they look like on the inside today.  And because of their operating structure, they are not required to disclose any of the information that we have been accustomed to in the 10-K annual reports filed by publicly traded firms.  We have no idea what their strategies are, the full extent of the risks to these strategies, or what their business models are.  Most importantly, we are clueless as to their financial condition and who their senior leaders are, or even what the governance structure looks like, much less its effectiveness.  Given the increasingly routine subpar performance of these large accounting firms, why do the regulators continue to let these firms get away with selling a clearly defective product.  What’s going on here?  Shouldn’t we know more about our “gatekeepers,” particularly since they appear to have left the gate wide open?

I am also somewhat troubled by the market’s recent reaction to KPMG’s recent partner scandal.  This is much, much more than simply another insider trading story.  I agree with James D. Cox, who called the case a “Bombshell that has the industry circling the wagons on training.”

There is simply no getting around it…this is a watershed event…this is a once in a generation occurrence…this is much worse than Deloitte’s insider trading problem.  Why?  This is about a major accounting firm violating the bedrock independence standards upon which the auditing profession is founded.  Mind you…this is not just another accounting restatement (although those are problematic as well).  So serious is the situation that KPMG actually withdrew its audit reports on multiple client financial statements for several years.  

The current KPMG debacle also highlights the failure of legislators and regulators to adequately address the independence issue last decade.  Although Section 201 of the Sarbanes-Oxley Act of 2002 created significant independence rules for non-audit (consulting) activities, they did little to beef up the actual policing of independence at accounting firms.  The limitations on consulting activities were largely a band-aid to address blatant independence violations during the Enron era.  Current professional standards largely require accounting firms to implement policies and procedures to provide reasonable assurance that personnel maintain independence.  And these can be quite “stringent” for KPMG and other accounting firms.  So, what’s the problem here?  The independence control procedures are largely self-reporting in nature.  That means that self-disclosure of independence violations is fundamental to most of the firm internal controls.  So, is it any wonder that KPMG was blindsided by its partner’s behavior. It appears that the firm actually was notified by federal investigators of the “rogue” behavior!  Shouldn’t the firm be ashamed that its own internal controls don’t work?  And we haven’t even discussed possible “failure to supervise” issues at KPMG, a topic that the Public Company Accounting Oversight Board will surely examine.

Given that independence, self-reporting, and firm culture all seem to be somewhat related, does this “rogue” KPMG partner’s behavior tell us anything about the firm’s culture?  Or about our society in general?  Here are a couple of examples from the recent press related to this 29-year veteran that concern me greatly:

This KPMG partner regrets his actions (now that he has been caught) after engaging in behavior that was “wrong” for a period of several years.  In fact, in his own words he felt guilty about it regularly, can’t explain it, and attributes it to “humans make mistakes.”

This KPMG partner tells us that he divulged “no real significant information,” and that his “take” was a watch discount, a couple of dinners, and a couple of thousand dollars in cash.  But instead we find out that he provided advance notices of earnings releases and merger plans, and in exchange “reaped more than $50,000 in cash and gifts, including a $12000 Rolex watch.”

Clearly, the “rogue” is trying to minimize his jail time, but I have yet another question.  Why does a senior, 29-year partner, with significant supervisory authority in one of KPMG’s largest offices behave this way?  Surely he didn’t need the money…the “why” is really nagging at me, and prompts me to question the firm’s culture. Shouldn’t we be concerned that this partner might actually reflect the system into which he was hired, trained, and promoted over almost 30 years?  Also, what about the effectiveness of ethics training at this firm and others, particularly at the senior level…and again what about leadership?

KPMG’s current catastrophe and PricewaterhouseCoopers’ recent quality control issues (which I discussed in “Is FASB Killing the Auditing Profession?”) reminded me of Marianne Jennings’ book titled “The Seven Signs of Ethical Collapse.”  As I reread Chapter One, I began wondering how many of the seven warning signs could apply to  the big accounting and auditing firms.  Three signals particularly jumped out at me:

Pressure to maintain those numbers – Given their size, one can only imagine what Big Four performance pressures might be.  After all they continue to protest regulatory attempts to improve audit quality, citing costs and pricing as issues.

Weak board – We have virtually little or no information on the governance of the large accounting firms.  But given their track record in protecting the public for the last half century, can’t we conclude that  there are some problems in this area?

Goodness in some areas atoning for evil in others – The big accounting firms deluge us (at least the academic community that is) with tales of their outstanding community and public service.  Could these actions be attempts to somehow make up for their “gatekeeper” failures?

In short, is there a festering cultural problem at these firms that makes them increasingly incapable of doing their duty to society?  After all, it was supposedly another “rogue” that took down Arthur Andersen in Houston, right?  I’m sorry…the “rogue” excuse is beginning to wear thin after all of the accounting and trading scandals we have witnessed recently.

Jennings in Chapter Ten also suggests that transparency may offer a solution to this “ethical collapse” issue.  She proposes clarity, honesty, and full disclosure.  Why can’t the large accounting and auditing firms “practice what they preach,” of their clients. Tell us more about who you are, what you do, and how you do it?  Admit your mistakes and tell us how you are going to fix it.  And then follow through and actually correct it!

Unfortunately, the spin to minimize legal exposure at KPMG has already begun. When this saga ends, we likely will conclude that we have seen this picture before.  A tale of weak and ineffective controls, missed signals, and greed…sound familiar?  Then, there is the standard “mea culpa” and promise to do better in the future. Shouldn’t the standard be higher for a firm of professionals?  One would think so…

And let’s not forget all the others that will use this case to promote their own policy initiatives.  Let’s try not to be blinded by the quick fix “solutions” (e.g., naming engagement auditors, audit rotation, etc.).  For example, while naming the auditors on an engagement sounds like a good idea, it might actually make things worse!  I would propose that good auditors (many of whom by nature are risk averse) might actually flee the large accounting firms if their names are disclosed, unwilling to put their limited wealth at risk for making an “honest” mistake in today’s litigious society.  This would leave the “rogue” risk takers to fill the engagement partner roles.  Just a thought…

The fundamental issues are, and have always been, independence and transparency.  Until we the investing public actually somehow become a contractual party to the audit with auditor hiring and firing authority (and I don’t mean via the board of directors), we are wasting our time.  We also need to know much, much more about the large accounting firms to better understand why their behaviors will likely never change in our lifetime (if ever).  Pretty grumpy, huh?

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

AuthorAnthony Catanach