/ 20 April 2018

Calls mount to split auditing firms

'The issue is being wrestled with globally
'The issue is being wrestled with globally

The scandals engulfing major auditing firms, most recently KPMG’s failures at VBS Mutual Bank, have reignited critics’ calls for major action to halt the loss of the profession’s credibility.

Splitting the dominant firms — KPMG, PwC, EY and Deloitte — into separate audit-only and advisory businesses is “an urgent national imperative”, according to Iraj Abedian, the chief executive of Pan-African Resources Investment and Research Services. Countries such as the United Kingdom are investigating this and, for South Africa, “the cost of not doing so is becoming excessive”, Abedian says.

The issue is being wrestled with globally, not only because of the many cases of auditors failing to spot corporate fraud but also because of the role these firms play in helping companies to shift profits and erode government tax bases.

There is growing concern that the independence of these firms’ audit services is being undermined by their competing and more lucrative advisory services. Tax justice advocates have suggested that governments need to consider nationalising auditing functions for the public good.

On Tuesday, South Africa’s auditor general, Kimi Makwetu, announced he was terminating the government’s contract with KPMG with immediate effect. Two partners resigned, ahead of disciplinary charges, in relation to their work done for VBS. The bank has been placed under curatorship and is the subject of a forensic investigation by the South African Reserve Bank.

Makwetu’s decision came hot on the heels of an announcement by VBS curator Anoosh Rooplal that he was withdrawing VBS’s latest financial statements because of “material misstatements”.

The VBS matter is the most recent of a number of scandals to rock KPMG. But it is not the only major auditing firm to find itself under public scrutiny. The crash of retailer Steinhoff, after “accounting irregularities” emerged at the firm, has thrown a spotlight on Deloitte, which audited Steinhoff’s books.

The big four firms dominate both the South African and the global sector.

Alex Cobham, the chief executive of the Tax Justice Network, says this kind of market concentration is always a concern, but it’s especially worrying in the case of the big four for three reasons.

First, this is a very large market with global ramifications. “We’re talking about a set of services that reach across all major and minor financial markets and economies. And, in some countries, only one or two of the big four have a major presence so these markets are even more at risk of a lack of true competition.”

They also exercise an “unhealthy degree of influence” over the setting of international and national accounting standards, and through the dominant “self-regulation” they have been able to obtain in many jurisdictions, he says.

Second, the range of services these firms offer is “fundamentally incompatible”. On the one hand, they offer “assurance” services, such as auditing, which should provide a guarantee of financial probity in companies’ accounts, or of appropriate behaviour in organisations, including governments, he says. On the other hand, the same firms are selling more profitable “advisory” services, “which are often specifically aimed at gaming the very systems and rules for which they are also supposed to provide assurance of compliance”.

As a result, highly dominant firms emerge with insurmountable, built-in conflicts of interest, because the profit motive will always dominate any incentive to provide a public good through effective assurance.

Third, the big four have become not only “too big to fail” but also too powerful to regulate. “Because the big four have been able to sell themselves as ‘neutral’ guarantors of financial probity in their audit and assurance work, they have a completely disproportionate power to determine, in the public mind, whether government behaviours are acceptable — up to and including a very active role in lobbying, for example, for lower corporate taxes or larger tax loopholes.”

This leads to all sorts of “public-private problems”, including extreme examples such as KPMG’s role in the “political circumcision” of the South African Revenue Service, he says.

Addressing their dominance requires an effective split between assurance services and advisory services, says Cobham.

But governments may need to go further, including considering nationalising audit functions, he adds, to recognise these services as a public good. Abedian says, however, this may be a step too far because the state does not have a track record for good performance and the auditing profession is “too vital to be subjected to such experimentation”.

The Financial Times reported last month that Britain’s Financial Reporting Council is seeking an investigation into splitting the big four firms.

Bernard Agulhas, the chief executive of the Independent Regulatory Board for Auditors (IRBA) believes South Africa should also consider this to enhance independence and “to clarify and delineate the role of external audit as a separate function to that of non-assurance or advisory functions”.

Corporate failures have highlighted the role of external auditors and a growing expectation gap between the role of audit firms and the external audit function, he says.

“It’s become such a concern for the IRBA that, in our efforts to strengthen the profession and restore credibility to the role of independent auditors, we identified the need to consider the benefits of moving to a model of audit-only firms to more clearly delineate the function of external audit, enhance independence and improve audit firm focus on audit quality.”

The IRBA intends to approach the British regulator and other global counterparts about the outcomes of their investigations, he says.

But the idea has been criticised by the industry. Mark Stewart, the chief executive of BDO South Africa, said in a statement that the proposal “lacks the clarity that would be expected from an announcement of this magnitude”.

“While we can understand why IRBA would seek such a change, it does require a better appreciation of why audits have failed, including downward pressure on fees, an increasingly complex environment, which has ever-shortening reporting deadlines, and the legal accountability of company boards themselves for decisions.”

Stewart says there is an appreciation that advisory services contribute greater profit with less risk than an audit and that this has contributed to the growth in advisory services.

But with this comes the question of whether companies’ audit committees are giving auditors the appropriate fees for the risk they are exposed to, he says.

The IRBA itself has been criticised, with claims that the repeated failures in the auditing profession point to its own inefficacy. But late last year, it recommended amendments to its governing legislation, the Auditing Profession Act, to the treasury. These are aimed at strengthening the legislation and increasing its powers. The amendments will introduce tougher sanctions in line with those pursued by international audit regulators. The proposed changes will also strengthen the IRBA’s powers of investigation and simplify the complexity of disciplinary hearings.

PwC’s involvement with VBS under scrutiny

For the past three years, embattled VBS Mutual Bank outsourced its internal auditing function to PwC, one of the big four accounting firms.

Besides the anger directed at the bank’s external auditors, KPMG, questions are being asked about PwC’s role in the collapse of the bank, particularly following the allegations of major governance failings and maladministration that emerged shortly after the bank was placed under curatorship last month.

According to Fulvio Tonelli, PwC’s chief operating officer, its mandate at VBS, which was determined by the bank’s management and approved by its board audit committee, “generally concerned the consideration of VBS’s risk management, internal control and governance processes”.

It was not part of the firm’s scope or engagement to consider, review or provide assurance on the financial statements for the past three financial years or to identify fraud, he said.

But court papers presented by the registrar of banks, Kuben Naidoo, reveal that issues such as internal controls and governance processes had caught the regulator’s attention. In a February letter written to former finance minister Malusi Gigaba, detailing several liquidity crises at the bank, Naidoo also highlighted other supervisory concerns.

These included inadequate corporate governance practices, inept risk management functions and practices, and significant growth in the balance sheet and new product offerings without a commensurate enhancement of internal controls.

According to Claudelle von Eck, the chief executive of the Institute of Internal Auditors South Africa, internal auditors do not prepare financial statements.

“Internal audit is not primarily a financial discipline, unlike its counterpart, external audit,” she said. “Internal audit … focuses more on the operational and governance activities of the organisation rather than ensuring that the financials are a true reflection of the state of the organisation, which is a requirement for statutory external audit.”

The responsibility lies with the leadership of the organisation, primarily the chief financial and executive officers, and the audit committee of a firm’s board of directors.

The key question that should be asked was whether the internal auditors picked up any red flags and whether they notified the audit committee.

“Then the next questions should be: What did the audit committee do about it?” said Von Eck.

Internal auditors were expected to comply with a number of international codes of practice and to consider all laws, standards and regulations impacting on the work they executed, she said.

But because the internal audit profession was not regulated, membership of the institute was not compulsory, unlike external auditors, she said. External auditors, which express an opinion on a company’s financial statements, must be registered auditors with the Independent Regulator for Auditors (IRBA) and are governed by the Auditing Profession Act.

Although the institute has an investigations and disciplinary committee to adjudicate complaints brought against individual members, it does not have any power to subpoena any information that belongs to an organisation, including internal audit reports.

Von Eck said PwC had advised the institute that it was doing its own internal investigation and it was “awaiting the outcome thereof”.

The VBS curator, Anoosh Rooplal, has suspended PwC’s work because of the financial position of the bank.

“I will be assessing the scope of their work that was done,” he said. “If the bank is to receive value from allowing the completion of certain assignments that PwC was still busy with, this will then be considered.”

If the internal audit was carried out by an auditor registered with the IRBA, however, it has the power to investigate. It is investigating KPMG lead partner, Sipho Malaba, in relation to his work on VBS.

But apart from an inquiry by the IRBA about the names of the engagement partners responsible for the internal audit engagement at VBS, PwC had not received any notice of any investigation involving PwC or any of its partners regarding VBS, said Tonelli.
— Lynley Donnelly