Holding audits to account

UK companies spend nearly £1.5bn each year on audits, but these offer little protection to stakeholders. It is time to replace them., Prem Sikka

• guardian.co.uk, Thursday 24 May 2007 08.00 BST

UK companies spend nearly £1.5bn each year on audits of their financial statements. Yet episodes like Hollinger, Farepak, Barings, Ahold, Equitable Life, MG Rover, Parmalat, Enron and others suggest that company audits offer little protection to stakeholders. It's time to replace them.

A common understanding is that auditors are independent of the company and its directors and thus in a position to make impartial judgements. This is one of the biggest hoaxes of all time. Company auditors are hired, fired and remunerated by directors though their decisions are rubber-stamped by shareholders. Many auditors also sell tax avoidance and a variety of consultancy services to client companies. This gives them a direct interest in corporate transactions and they have rarely exposed any shady dealings. Despite having statutory access to almost all records, officers and employees of the company, auditors deny obligations to detect and report fraud. Their files are not available to any stakeholder to see what they knew.

Though auditing firms carry the soubriquet "professional", they are commercial organisations. In pursuit of profits, they continued to accept Maxwell, BCCI, Enron, WorldCom, Transtec, Versailles Group, Hollinger and others as clients. They are adept at prioritising the interests of directors above those of any other stakeholder. In the case of the frauds by Robert Maxwell, page 328 of a report by the Department of Trade and Industry (DTI) inspectors noted that the auditing firm consistently agreed accounting treatments of transactions that served the interest of Maxwell and not those of the trustees or the beneficiaries of the pension scheme, provided it could be justified by an interpretation of the letter of the relevant standards or regulations. The audit firm's strategy, as noted on page 381 of the DTI report, was summed up by a senior partner who told staff that, "The first requirement is to continue to be at the beck and call of RM [Robert Maxwell], his sons and staff, appear when wanted and provide whatever is required".

Scholarly research shows that nearly 60% of audit staff admit to either falsifying audit work, or not doing it at all. Audits are time and labour intensive. To boost their profits, auditing firms continue to reduce time budgets. They hope that audit trainees will work weekends and evenings for nothing to finalise the audit. The routinised audit work is boring and time consuming. To ensure that they are not seen to be unproductive or over budget, audit staff avoid awkward looking items and often pretend to have checked items that have not even been examined. Over the years, I have forwarded this research to the Department of Trade and Industry (DTI) and the UK auditing regulators, but none have ever examined the organisational values of auditing firms.

The threat of lawsuits can force auditors to be more vigilant, but this has been diluted. Generally, auditors only owe a "duty of care" to the company as a legal person rather than to any individual shareholder, creditor or other stakeholder. As page 19 of a UK Treasury-sponsored study (pdf) notes, individual stakeholders cannot successfully sue auditors even when they can show that "the auditors had been negligent". Most lawsuits against UK auditing firms are brought by other accountancy firms, acting in their capacity as liquidators. Ordinary stakeholders rarely get much out of this.

Auditing firms already trade as limited liability companies and limited liability partnerships. The prospects of making them accountable for poor audits are further eroded by "proportionate liability" introduced by the Companies Act 2006. This enables directors and auditors, subject to shareholder approval, to negotiate limits to auditor liability, this makes it even harder to bring negligent auditors to book. The policy was first introduced in the US in the mid-1990s and played a key role in the Enron and WorldCom audit failures. Now major firms are campaigning to place an artificial "cap" on auditor liability and their US political donations are about to pay high dividends. The EU and UK are keen to follow suit. Under a cap the outcome of lawsuits would have no relationship to the extent of auditor negligence, or the losses suffered by that negligence.

Serious doubts about the auditors' ability to deliver good audits are also created by business developments. It is doubtful that auditors can effectively audit banks operating from 140 countries. The traditional ex-post audits cannot perform any meaningful checks on the world of instantaneous transfers of money. Neither are auditors able to deal with complex financial instruments. Many major companies manage their risks by placing clever bets on the movement of exchange rates, interest rates and prices of commodities. Depending upon the outcomes, the value of such contracts (derivatives) can range from zero to several millions. The collapse of Long Term Capital Management (LTCM) showed that even the Nobel Prize winners in economics could not work out the value of such financial instruments. Auditors are certainly not equipped with such skills and are simply rubber-stamping the figures produced by management.

Company auditors have shown little interest in becoming independent and have fought tooth and nail to preserve their right to sell consultancy to audit clients. The regulators have shown little interest in protecting the interests of stakeholders or looking at the internal workings of auditing firms. The liability regimes encourage inertia and audit failures. Traditional audits cannot audit banks or the financial statements of major corporations. Yet people do need to protect their savings, pensions and investments from fraud. So rather than constantly trying to revise the traditional auditing model and rescue the failed technology, alternatives need to be developed.

One possibility is to abolish the annual statutory audit and require all companies to have insurance cover equivalent to (say) twice the value of their assets so that defrauded stakeholders claims can be satisfied. £1.5bn can buy a lot of insurance cover and details would be publicly known. To minimise the risk of misinformation, laws would need to be changed to make all company directors personally liable for knowingly publishing misleading financial statements. Corporate laws will need to be strengthened to ensure that companies publish the required information. Of course, insurance companies need to assess the fraud risks and may use the services of accountancy firms to make assessments of corporate internal controls and fraud potential. It is extremely unlikely that, under these arrangements, accountancy firms would be able to deny any obligations to look for fraud and stakeholders will not have to put up with the pretensions of independent auditors.

LATELINE

TV PROGRAM TRANSCRIPT

LOCATION: abc.net.au > Lateline > Archives URL: http://www.abc.net.au/lateline/s595990.htm

Broadcast: 1/7/2002

Wall Street rues accounting scandals

As economists win back from Wall Street share analysts the right to tell the history of the bubble economy of the 1990s, you may see the phrase "collective madness" repeated over and over again. And they'll have some fine examples to choose from when trying to illustrate that point. Prime among them will be 'Enron', and now 'WorldCom'. And the questions that'll be asked over and over again will be -- how was this allowed to happen? What happened to the auditors whose job it was to protect the public interest and make sure the books were not cooked?

TONY JONES: As economists win back from Wall Street share analysts the right to tell the history of the bubble economy of the 1990s, you may see the phrase "collective madness" repeated over and over again. And they'll have some fine examples to choose from when trying to illustrate that point. Prime among them will be 'Enron', and now 'WorldCom'. And the questions that'll be asked over and over again will be -- how was this allowed to happen? What happened to the auditors whose job it was to protect the public interest and make sure the books were not cooked? Our next guest says corporations have been left to effectively regulate themselves and that auditors have become complicit in the great game. Professor Prem Sikka is the author of a new book, Dirty Business: the unchecked power of major accountancy firms. And I spoke to him in London a short time ago, just before the book was launched in the House of Commons. TONY JONES: Prem Sikka, why do you say that more Enron and WorldCom style scandals are inevitable? PROFESSOR PREMIER SIKKA, ESSEX UNIVERSITY: Well, we have to look at the cultural values by which the business people live. We live in a world where the idea of deregulation and enterprise culture has been dominant, and people are told as long as you make money, that is okay. People are fairly used to ducking and diving, trying to avoid rules and regulations to enrich themselves and there is a dominant belief that the company executives should be paid by reference to the profits they publish, and that gives them economic incentive to massage the numbers, because the more they massage the numbers, higher salaries, higher bonuses, higher share options they receive. So that people are actually being rewarded on a system which encourages exactly what many of us are being concerned about. TONY JONES: But we've never seen fraud on this sort of scale before. And I'm wondering is this about the new economy bubble, and the extraordinary and unreachable expectations that were put on company profits and what they call "the new paradigm" -- that ordinary judgments of a company just simply didn't matter any more? PROFESSOR PREM SIKKA: Well, I think as companies have become larger, inevitably scandals would be larger as companies have become global, therefore, it's inevitable that the impact of WorldCom -- and World'Con', is it - and Enron will be felt worldwide. And basically the captains of industry have been able to secure fairly ineffective systems of regulations for themselves and they have surrounded themselves with advisers who are willing to enable them to rob companies. We have to remember that all these frauds have been carried out by people who are not poor. They've been highly paid, highly educated, living in leafy suburbs, driving the most expensive cars, sitting in plush city centre offices devising processes which have resulted in daylight robberies. And, you know, you no longer have to go out and rob anything, you simply hire a firm of accountants to help you. TONY JONES: You don't then think that this is a sort of pathology of the new economy, that this has come with the new high-tech bubble economy? PROFESSOR PREMIER SIKKA: Well, I think that has clearly aided it, but we must not forget that even before this new economy, we've been having worldwide scandals. When you look at the UK for example, in 1991, we had the Bank of Credit and Commerce International, which was the biggest banking fraud of 20th century. The Bank of England closed the BCCI bank down in 1991. To this day, 11 years later, the British Government has failed to commission an independent inquiry into the fraud and into the audit failures. So the problem is that governments are protecting major corporations and accountancy firms. When you look at the US, you see that the SEC's funding has been eroded and it's not really been in a position to call companies to account. Even then, the SEC has done a good job, despite the limitations on its funding. Over the last two, three years some 700 companies have been forced to restate their accounts in the US, and in no case did any accountancy firm blow the whistle. TONY JONES: Let's go back to WorldCom because the former CEO of WorldCom, Bernie Evers, seems to be almost in a category of his own. How much blame in the end is going to be laid specifically at his feet, do you think? PROFESSOR PREM SIKKA: Well, I think someone should throw the book at him. Clearly, the directors of major companies are culpable, but I have to remind people that no-one is actually born bad. We all have the same DNA structure. It is the system, the culture, which makes people bad. This is why we need good regulation to curb people's anti-social tendencies. We have to make sure that people do fear being caught, being checked, being fined, being imprisoned. But in a world of deregulation, those kind of things have become a dirty word. And now we are seeing the cost of deregulation. People imagine that if you regulate something, it costs money. Now we are seeing that if you don't regulate, a lot of innocent investors, creditors, employees and pension scheme members are suffering all over the world. TONY JONES: What sort of regulation should there have been in the WorldCom case which might have stopped that from happening, because in that case it seems extraordinary that $4 billion seems to have gone completely unnoticed in the profit figures by the auditors? PROFESSOR PREM SIKKA: Well, I don't think we are completely going to stop these things unless we change the cultural values by which the big business operates. But, meanwhile, if you are going to enter Sumo wrestling, you have to make sure you have good protection, good cover, and that good protection, good cover needs to come at a number of levels within companies. If you look at WorldCom, Enron and other scandals, every one of them had an audit committee, every one of them had non-executive directors, but they were all friends of the directors. And these guys, who are non-executive directors, were simultaneously directors of tens and hundreds of other companies, barely spending more than three, four hours a week or a month even looking at each company's affairs. They were totally ineffective. We need to change the way the companies are governed. We need to make sure that directors are elected by shareholders and employees. We need to make sure that the non-executive directors are elected by shareholders and employees so that we give employees an incentive to blow the whistle. We give employees a reason to take more interest in the affairs of a company. We need also to change the regulatory system. And we need -- you know, we are trying to deal with major world corporations, so therefore we need to make sure our regulatory system is beefed up and the punishment has to be quick and fairly hard. And I don't think we can necessarily rely on major accountancy firms that much because time and time again they have let people down. And in a book I'm releasing today, we are reporting that some of the biggest accountancy firms in the world have been laundering money, engaged in tax evasion, bribery. And I think we need to ensure that at the end some kind of truth is told. And we should be willing to allow major organisations, like the Securities Exchange Commission or their equivalents all over the world -- inland revenue authorities, the taxation authorities and other public bodies -- to do the audit, because these people will not agree to become auditors and simultaneously consultants and advisers to the management. And what we've been finding is, in accountancy firms, one floor does the audit, another one dreams up creative accounting and financial engineering, another one is dreaming up on how to avoid the public humiliation of companies. And these firms have been playing all sides of the street, and that is simply not right. TONY JONES: Well, to what degree, though, can you break up the relationship between corporations and their auditors in a free market? PROFESSOR PREM SIKKA: Well, first of all, I'm not sure that we have a free market, when the world accountancy is dominated by four or five firms and almost anything you look at you will find more than 50 per cent of the world's trade is carried out by 200 companies, and you will find that 50 of the world's largest -- if you look at the 200 top economies, 50 are actually corporations. So I'm not sure that we are necessarily talking about a free market in the classic sense. What we are looking at is concentration of corporate power. And it should not be beyond any government in any part of the world to introduce regulation which is independent, ie audits are really done by independent organisations. At the end, what really matters is protection for the people. We are not running audits or publishing accounts to enable accountancy firms to make money. We have lost sight of these things. TONY JONES: Finally, Prem Sikka, have the equity markets actually weathered this storm, as some people are saying now, or is there more to come? The doomsayers, for example, are suggesting this could be, or looks very much like, the series of events that led up to the Great Depression. PROFESSOR PREM SIKKA: Well, I think the equity markets would go up and down, and clearly, the government ministers and regulators are trying to talk the markets up, and a good thing, as well, because many of our pension moneys are invested in various companies. But even when the equity markets go up, the damage is done to people. For example, lots of people have lost their jobs or will lose their jobs. Banks will be writing off bad debts, which could result in a credit crunch for all of us. Insurance companies will be forced to meet some claims, which mean all of us will be paying higher insurance premiums next year, or within the next few months -- on our cars, on our houses, on our contents, on our travel, and everything else. And many of the pension funds actually will be writing off their investments, which mean many people will actually receive a lower pension. So even if the markets bounce back, that does not mean that the damage to ordinary people has not been done. TONY JONES: We will have to leave it there, Prem Sikka. Thank you very much for taking the time to join us tonight on Lateline. PROFESSOR PREM SIKKA: It's been a great pleasure.