The investment community relies on the accounting industry to prevent misconduct and fraud. But what happens when the auditors of corporate America fall down on the job and betray their mandate to ensure transparency and accuracy in financial reporting? Investors endure massive losses -- as we saw after a series of audit failures related to massive and widespread securities fraud in the early 2000s.
Unfortunately, the auditing profession continues to be plagued by misconduct: auditors ignore repeated warnings by whistleblowers, turn a blind eye to questionable receivables, change calls on the propriety of problematic accounting by clients and even undermine the regulatory agencies tasked with monitoring them.
That said, the institutional investor community is uniquely positioned -- and has proven able -- to hold auditors accountable. There is much that it can and should do to continue to improve the landscape.
Gatekeepers gone wrong
In the words of Securities and Exchange Commission Chairman Jay Clayton: "Audited financial statements are at the heart of the SEC's disclosure-based regulatory regime ... independent audits give investors confidence that those statements can be trusted."
Yet, auditors face a conflict of interest between their clients' interests and public transparency, and many audits frequently mislead investors. The International Forum of Independent Audit Regulators has found that 40% of the 918 audits inspected last year contained serious errors, including issues pertaining to accounting estimates and internal control testing. Frequently, accounting estimates are not based upon reasonable assumptions and do not consider contrary or harmful facts. Internal control testing might not sufficiently test for the accuracy and completeness of information provided by the client's managers. And bad financial news is frequently buried in "obscurely worded notes."
Over the past few years, numerous high-profile audit scandals have involved the so-called Big Four accounting firms -- PwC, Deloitte, KPMG and Ernst & Young. These scandals have involved high-profile companies in the U.S. and internationally, including Petrobras (Brazil), BHS (U.K.), Carillion (U.K.) and major state institutions. Despite these scandals, the Big Four continue to monopolize the industry and audit more than 95% of the U.S.' largest companies.
Further, in January 2018, the U.S. Attorney for the Southern District of New York charged three executives at KPMG with multiple criminal and civil violations, including conspiracy, wire fraud and misuse of confidential information related to the firm’s attempts at corrupting the function of the Public Company Accounting Oversight Board, a key regulator of the industry. Among other revelations, the indictment details how KPMG hired former PCAOB employees who then provided stolen confidential information detailing upcoming audit inspections.
Investors can and must fight back against auditor fraud.
While it is not particularly common to sue outside auditing firms, the institutional investor community has had significant success over the past two decades holding auditors accountable, obtaining billions of dollars in recoveries through securities class actions. Recently, this has even become a global phenomenon. In Australia, PwC recently paid $67 million to resolve a securities class action. In Canada, Ernst & Young was required to pay $118 million in 2012 in what emerged as the country’s largest ever class action settlement relating to audit fraud.
However, litigation is a last resort to resolve the results of systemic misconduct.
Investor advocacy is a key tool in combating auditor misconduct before it can take root and visit losses on investor portfolios. Shareholder advocacy and action has resulted in meaningful corporate governance changes that pre-empt opportunities for wrongdoing, including obtaining investor input on selection of an auditor and developing mechanisms to enhance transparency. For example, after KMPG failed to spot crucial accounting errors leading to SEC and Consumer Financial Protection Bureau investigations, shareholders pressured General Electric and Wells Fargo to switch auditors for the first time in nearly a century. Similarly, after a major data breach in 2017, Equifax shareholders called for restructuring of the board and greater audit quality control policies.
Despite these efforts, and significant regulatory steps taken after the wave of scandal in the early 2000s, auditor fraud shows no signs of stopping. The government might make good rules, but greed is forever busy. The institutional investor community — i.e., the “owners” of our most cherished corporations and institutions — are uniquely positioned and empowered to address and halt this worrying trend.
There are numerous ways public pension funds and other institutional investors can leverage their power to encourage and facilitate better conduct by the auditing profession upon which our markets rely so critically:
- Become aware of the role that auditors play in securities fraud.
- Advocate for financial independence between auditors and companies being audited.
- Petition for greater transparency and oversight within a company, such as demanding creation of a multitiered independent review body within organizations to check audits
- Lobby for key auditor performance indicators based upon audit quality, not the client company’s performance. These auditor performance indicators could be mediated by a third party or outside certifying organization, which would review and certify the audits.
- Demand regulations requiring Big Four auditors to work with outside audit firms to create joint audits for certain significant transactions. These outside audit firms could also provide a second review of primary audits, thereby serving as a “check” on Big Four audits.
- Propose a requirement that companies rotate auditors at selected intervals, such as every three to five years. Under such a requirement, auditors could be capped on the number of times they audit a particular company within a given time period, such as being limited to auditing the same company once every 10 years.
- Demand auditors impose requirements that eliminate or reduce bias, such as blind reviews of a certain financial statements.
It is clear that the near-monopoly of the accounting field by the Big Four, if unchecked, will continue to perpetuate auditor fraud. Public pension funds and other institutional investors play a key role in fighting back.