Further Memorandum submitted by Professor
Prem Sikka
THE INSTITUTIONALISATION OF AUDIT FAILURES:
SOME OBSERVATIONS
SUMMARY
In modern societies, external auditing is promoted
as a technology that enables stakeholders to manage, control and
prevent risks. However, a steady stream of audit failures shows
that it is also a technology that harms people. Audit failures
are routinely implicated in the loss of jobs, homes, savings,
pensions, taxes and investment. The institutionalisation of audit
failures draws attention to the culture and values prevalent within
accountancy firms. This paper provides some illustrations to argue
that the organisational practices of accountancy firms are geared
towards advancing their narrow economic interests, often at the
expense of wider social interests.
In everyday life, people encounter varieties
of auditors ranging from immigration control officers, Inland
Revenue, Customs and Excise, Health and Safety inspectors and
many more. In no case does the auditee appoint and remunerate
the auditor. However, that is the normal position in company audits.
The basic audit model expects one set of capitalist entrepreneurs
(accountancy firms) to regulate another (company directors). Profits,
income and appeasement of clients measure the success/failure
of both. Serving the public interest does not form any part of
this equation.
In pursuit of profits, accountancy firms have
been using audits as a market stall to sell consultancy. The internal
organisation of accountancy firms encourages falsification of
audit work. The absence of "duty of care" to individual
stakeholders affected by audits dilutes the economic incentives
to deliver good audits. The longevity of auditor appointments
encourages personal relationships with company directors. Frequently,
audit staff are auditing their one time senior now enjoying a
directorial position in a client company.
In principle, the legal, educational and regulatory
environments could check such predatory practices, but they are
weak. Accountancy trade associations rather than an independent
regulator regulate auditors. The main responsibility for the poverty
of auditing practices rests with the Department of Trade and Industry
(DTI). However, it continues to pass the buck to the accountancy
trade associations. It has done little to check the poverty of
auditing practices.
Overall, the paper argues that in the current
UK environment, audit failures are inevitable and will continue
to hurt innocent stakeholders. The paper suggests some public
policy alternatives and reforms.
THE INSTITUTION
OF AUDIT
FAILURES: SOME
OBSERVATIONS
We need courage, not so much to endure as to act.
All resignation stunts us. We have to have courage, to take future
in our hands. If the law is oppressive, we must change the law.
If the tradition is obstructive, we must break the tradition.
If the system is unjust, we must reform the system" (Winifred
Holtby, in South Riding)
INTRODUCTION
In modern societies, people enter into transactions
(eg investments, pensions, savings, food and transport) with faceless
strangers. There is a recurring danger that strangers may be untrustworthy
and may abscond with the resources and/or indulge in harmful activities.
As part of modernity's concerns about managing risks[26],
people are increasingly encouraged to value surveillance technologies
and place trust in socially accredited experts with expert knowledges
(Power, 1997). Following a spate of 19th century financial scandals
that had a capacity to undermine confidence in capitalism, the
state invested in systems of surveillance and external auditing
came to be institutionalised as a trust engendering technology
(Sikka et al, 198). Auditing increasingly functions as
a political technology enabling the state to regulate banks, insurance
companies, pension funds and markets (Arnold and Sikka, 2001;
Mitchell et al, 2001).
Auditing has been a real boon for accountancy
firms. There are no state guaranteed monopolies for engineers,
scientists, mathematicians, designers, computer experts and other
wealth creators, but audit work is reserved for accountants belonging
to a handful accountancy trade associations. Nearly 600,000 limited
companies plus hospitals, universities, local authorities, pension
funds, schools, trade unions, housing associations and charities
need to have their books audited by an accountant. Not surprisingly,
accountancy is an attractive career. Britain has around 250,000
qualified accountants, more than rest of the European Union put
together. Between 10 per cent and 20 per cent of all university
graduates are making a career in accountancy. Despite this huge
investment in economic surveillance, Britain does not have superior
corporate governance, freedom from frauds, better protection for
stakeholders or business accountability.
Today accountants rather than Parliament decide
what counts as solvency, liquidity, asset, liability, equity,
debt, income, expense, profit and loss. Their decisions affect
shareholders, creditors, employees, pension scheme members and
other stakeholders. The huge social investment in economic surveillance
gives accountants security of income, job and status. On the back
of the state guaranteed market of auditing, accountancy firms,
have become consultancy supermarkets.
Major firms earn less than 40 per cent of their
fees from auditing and accounting services. In pursuit of higher
fees they use audits to sell executive recruitment, internal auditing,
advice on mergers, downsizing, trade union busting and tax avoidance/evasion.
For a fee they will front shell companies, act as company directors,
post boxes, print T-shirts and badges, lay golf courses, launder
money and engage in bribery and obstruction of legitimate inquiries
(Mitchell et al, 1998; 2002). Parliament passes legislation
to curb tax avoidance/evasion, only for major firms to find new
ways of avoiding/evading taxes. They are transparently and even
self-consciously engaged in creative accounting and rule avoidance.
Paralleling a fateful remark of Gerald Ratner's to the effect
that his shops sell "crap", the chairman of Coopers
and Lybrand (now part of PricewaterhouseCoopers) openly stated
that "there is an industry developing, and we are part of
it, in [accounting] standards avoidance" (Accountancy Age,
19 July 1990, p 1).
In the pre-Enron world, just five firms dominated
the global accountancy scene. Their income is greater than the
Gross National Product (GNP) of many nation states.
FEE INCOME OF ACCOUNTANCY FIRMS
| Firm | UK Fee Income
£millions
| Global Income
US$ billions |
| PricewaterhouseCoopers | 2,120
| 22.3 |
| KPMG | 1,160 | 11.7
|
| Deloitte & Touche | 796
| 12.4 |
| Ernst & Young | 626 |
9.9 |
| Arthur Andersen | 619 | 9.3
|
| | |
Sources: Accountancy Age website (accessed on 4 April
2002); Accountancy, February 2002, p 13.
Rather than being regulated by a single independent regulator,
accountancy business is regulated by 23 overlapping regulators
(see Appendix 1). Even then there is no independent complaints
investigation procedure and no ombudsman to provide speedy and
cost effective adjudication of complaints. None of the regulators
owes a "duty of care" to any individual affected by
their activities.
Despite making decisions that affect the daily lives of people,
accountancy firms are not required to publish any information
about their affairs or their relationship with audit clients.
Unlike the producers of sweets and potato crisps, auditors do
not owe a "duty of care" to any individual stakeholder
affected by their negligence. It is as though their accountability
has been organised off the political agenda. It is noticeable
that accountancy firms hire MPs to advance their economic interests
(for example, former MPs Tim Smith and Jeremy Hanley were on the
books of the ICAEW and accountancy firms. Stuart Bell MP and Peter
Mandelson MP act as consultants for Ernst & Young). A weak
legal, regulatory and accountability environment has failed to
persuade accountancy firms to reflect upon the consequences of
their failures. Their failures have caused loss of homes, jobs,
savings, pensions, investments and tax revenues (for example,
see Mitchell et al, 1991; Sikka and Willmott, 1995a, 1995b;
Edwards and Shaoul, 1999; Sikka, 2001).
The damage done to people's lives by audit failures is well
documented. Audit failures played a part in a crisis for 30,000
Maxwell pensioners (House of Commons Social Security Committee,
1992). Audit failures played a part in the closure of Polly Peck
and the loss of 17,227 jobs (Mitchell et al, 1991) and
losses to 11,000 shareholders of Sound Diffusion Plc (Department
of Trade and Industry, 1991a). Auditors failed to note that frauds
that led to the conviction of five officials of the Baptist Foundation
of Arizona on 32 counts of fraud, racketeering and theft. 11,000
investors lost £400 million (Daily Mail, 2 April 2002).
The US Senate's report on the closure of the Bank of Credit and
Commerce International (BCCI) concluded, "there can be no
question that the auditing process failed to work" (US Senate,
1992, p 253). The audit failures were associated with the loss
of 14,000 jobs and losses to some one million bank depositors
with deposits of US$ 1.85 billion (US Senate, 1992, p 75). The
Senate Report accused auditors of being a party to a "cover
up" (US Senate, 1992b, p 276) and causing "substantial
injury to innocent depositors and customers [emphasis added] of
BCCI" (US Senate, 1992, p 5). In the aftermath of the 1970s
audit failures at secondary banks, property and insurance companies,
the UK taxpayer had to spend £3,000 million to bail out the
sectors (Reid, 1982). The frauds and audit failures at Barlow
Clowes required the British taxpayer to spend £153 million
in compensation to investors (Department of Trade and Industry,
1995; Parliamentary Commissioner for Administration, 1989). The
real/alleged audit failures in the US Saving and Loans industry
may have cost the taxpayers between $400-$500 billion in bailouts
(Pizzo et al, 1990). The collapse of Enron, the world's
largest bankruptcy, is associated with audit failures in which
the audit firm devised corporate structures, created numerous
subsidiaries (including 900 offshore) and financial transactions.
Enron auditors, Arthur Andersen, performed consultancy services,
including internal audit[27],
and just as the regulators were poised to examine the failures,
the firm allegedly shredded a number of relevant electronic and
paper documents[28].
(Financial Times, 11 March 2002).
Almost every week, newspapers report some new incidence of
audit failure. These are brought to public attention by whistleblowers,
investigative journalists or by victims of frauds rather than
by auditors, accountancy trade associations or any government
department. In response, the Department of Trade and Industry
and the auditing regulatory merely wring their hands. The standard
response to audit failures is to blame someone else, individualise
audit failures, revise auditing standards, codes of ethics, regulation
and calls for better training of accountants (Sikka and Willmott,
1995a; US Department of Labor, 1997). Little attention is paid
to the regulatory failures, conflicts of interests and the culture
of accountancy firms. As a result, audit failures continue unabated
and are firmly institutionalised.
This paper argues that the ability of accountancy firms to
cause substantial injury to depositors, customers, employees,
creditors, shareholders, pension scheme members and other stakeholders
is, amongst other things, the product of their organisational
values and cultures[29].
The prime responsibility for scrutinising the organisational practices
of accounting firms and curbing their capacity to do social harms
rests with the government, especially as it has granted a monopoly
of the external auditing function to accountancy firms. However,
successive UK governments have shown little willingness to undertake
such investigations. They have delegated the responsibilities
to the accountancy trade associations, which act as sponsors,
promoters, defenders and regulators of the UK auditing industry
(Sikka and Willmott, 1995a, 1995b). The auditing regulators pay
little attention to the role of organisational practices and values
in institutionalising audit failures and social harms.
This paper is divided into four further sections. The first
section argues that modernity generates risks and calls for regulation.
Due to the systemic limits on expert knowledge and the private
economic interests of the experts, the negative consequences of
reliance upon experts (eg auditors) are institutionalised. The
second section provides some illustrations that raise questions
about the organisational culture and practices of auditing firms.
They suggest that in pursuit of profits, auditing firms are rarely
concerned about the consequences of their practices for the welfare
of audit stakeholders. In principle, educational, legal and other
regulatory arrangements could check the harmful effects of the
organisational culture of accountancy firms. However, the third
section argues that the legal and institutional arrangements for
regulating auditing are weak. The regulatory bodies have a cosy
relationship with auditing firms and are more concerned to defend
and advance the economic interests of auditing firms rather than
those who might bear the negative consequences of auditing. The
fourth section concludes the paper with a summary and discussion.
SEEDS OF
AUDIT FAILURES
Auditing is frequently promoted as a risk management technology.
The very idea of "risk", in a modern context, assumes
that nothing is preordained and fixed and that the social arrangements
are the outcome of human action rather than the invisible hand
of fate. Modernity creates the feelings that future misfortunes,
threats, harms, hazards and dangers can be prevented, controlled
or managed by investment in suitable technologies, modes of government,
forms of surveillance, accountability, bureaucracy, institutional
structures and trust engendering technologies. Modernity encourages
the belief that the social world can be controlled by investment
in modes of objective knowledge and rational thinking and that
the risks can be calculated and predicted.
Many of the risks associated with modern life are not directly
accessible to the senses. They cannot easily be seen, smelt, observed,
or felt by human bodies. Rather than relying upon local knowledges,
traditions, habits, or observations, the construction of risks
is mediated and regularised by reliance upon expert knowledges
and experts that people rarely meet or encounter in everyday life.
By appealing to their socially constructed credentials, experts
solicit "trust" and seem to hold out the promise of
certainty and bringing the future under control. People are encouraged
to look to the assumed experts to diagnose problems and offer
advice. As a result, "risk" analysis, risk management
and surveillance is big business, providing employment for thousands
of consultants, advisers, auditors and experts.
The limitations of expert knowledge are often highlighted
by unexpected events (eg diseases, corporate failures) which show
that the concepts and theories advanced by experts cannot adequately
grasp reality. As modernity is accompanied by intense fractures
and fragmentation of daily life, it also produces social conflicts.
In societies marked by social divisions and antagonisms emanating
from inequalities relating to class, gender, age, ethnicity, wealth
and income, the significance and meaning of expert knowledge cannot
be fixed in any permanent sense. The meanings are open to intense
struggles, especially by those who claim to have a direct interest
in promoting particular interpretations of risk objects and practices.
The experts often deflect public criticisms by engaging in "politics
of blame" by placing the critics/victims in negative spaces
and arguing that the public expects too much, or that they had
been misled by someone else.
In modern societies, expert knowledges and experts reside
in capitalist organisations that generate pressures to prioritise
fees, income, profits and market shares over compassion, care
and social responsibility. In pursuit of private gains, some organisations
facilitate technologies and expertise that cause death and genocide
(Black, 2001) and generally promote profit over people (Chomsky,
1999). In pursuit of private gains, food experts have sanctioned
the consumption of unfit food (Schlosser, 2001; House of Commons,
2000), financial experts have sanctioned the sale of undesirable
pension schemes (House of Commons Treasury Committee, 1998), accountants
have laundered money (Mitchell, Sikka and Willmott, 1998), and
auditors put appeasement of company directors above the interests
of employees, pension scheme members and shareholders (Department
of Trade and Industry, 2001). The reliance upon experts is double-edged.
It oils the wheels of economy and society, but it also generates
"new ignorance with knowledge" (Douglas and Wildavasky,
1983, p 49) and facilitates physical, economic and social injuries
to a large number of people and society generally. Seemingly,
the social production of wealth, certainty and regulation is systematically
accompanied by social production of risks (Beck, 1992). It is
rarely accompanied by reflections upon the organisational values
and practices of the assumed experts. As the potential for harm
is institutionalised, a recurring question is who can be trusted?
Such questions lead to calls for (re)regulation or the (re)establishment
of trust.
Modernity's concerns about risk and regulation are mirrored
in the process of auditing. There is a strongly held view that
audit risks can be managed or minimised by the development of
objective knowledge in the shape or probabilities and statistical
sampling (for example, see Auditing Practices Board, 1995a, 1995b).
Auditors are encouraged to make predictions about the future by
using past accounting numbers[30]
and mathematical models (Altman, 1968; Altman and McGough, 1974;
Auditing Practices Board, 1995c) and shield themselves from threats
through insurance cover. Alternative forms of knowledge and social
understanding have been driven off the educational schema and
rulemaking considerations. No amount of sampling, analytical review,
or predictive models require auditors to reflect upon the social
consequences of their actions. These technologies may help to
minimise audit effort, increase profits, and possibly protect
audit firms/partners from the consequences of real/alleged audit
failures, but rarely encourage reflections upon the negative social
consequences of the organisational practices of accountancy firms.
In market economies, company audits are performed by capitalise
organisations whose success/failure is measured by fee income,
profits and number of clients and market share. Within accountancy
firms the emphasis is "firmly on being commercial and on
performing a service for the customer rather than on being public
spirited on behalf of either the public or the state" (Hanlon,
1994, p 150). Accountancy firms enjoy a monopoly of the state
guaranteed market of external auditing, but the procurement of
clients and fee income is heavily dependent upon personal relationships
with company directors who need to be persuaded to hire a particular
firm of auditors. Securing the office of the auditor is important
because it also enables the firm to sell lucrative consultancy
services. Accountancy firms are part of an "enterprise culture"
that persuades many to believe that "bending the rules"
for personal gain is a sign of business acumen. Stealing a march
on a competitor, at almost any price, to make money is considered
to be an entrepreneurial skill, especially where competitive pressures
link promotion, prestige, status and reward, profits, markets,
niches with meeting business targets.
The expansion of the entrepreneurial accounting firm has
not been accompanied by moral constraints that require consideration
of the social consequences of their organisational practices.
In such an environment, numerous practices are considered to be
acceptable as long as they generate private profits. The "failure"
resides not in instituting dishonourable, predatory or anti-social
practices but in being exposed or caught, as it can damage the
carefully cultivated veneer of respectability and professionalism
and limit the possibilities of securing fees and profits. The
likelihood of being caught and punished can stimulate reflections
upon organisational practices. Such possibilities can be created
by the formulation of strong regulatory arrangements enforced
by the state. However, the state's ability to intervene is constrained
by the deregulationist discourses that seek to limit its ability
to monitor the internal practices of accountancy firms. The increasing
reliance of political parties and governments upon private monies
also constrains the state's ability to institute regulation that
is opposed by major businesses (Chomsky, 1999; Monbiot, 2000).
Faced with material and ideological constraints, the state has
delegated the regulation of auditing to accountancy trade associations.
Following the Companies Act 1989, the accountancy trade associations
are expected to regulate the auditing industry and investigate
real/alleged cases of audit failures. They are expected to promote,
defend, regulate and prosecute auditing firms, but have no independence
from the auditing industry. Rather than examining the organisational
values and cultures giving rise to the audit failures the accountancy
bodies individualise the failures (Joint Disciplinary Scheme,
1999) and campaign to secure liability, tax and other concessions
for the firms. This way attention is deflected away from the organisational
practices and values of accountancy firms. In a weak regulatory
environment, organisational practices of accountancy firms go
unchecked, audit failures remain institutionalised and their capacity
to do harm[31] to people
has become the subject of newspaper headlines.
The remainder of this paper draws attention to some auditing
practices that offer insights into the organisational culture
and practices of accountancy firms. These may help to increase
profits and revenues, but are rarely accompanied by reflections
upon their consequences for the welfare of audit stakeholders.
ORGANISATIONAL PRACTICES
OF AUDITING
FIRMS
Pursuit of Profits
In common with other commercial enterprises, auditing firms
exert pressures on audit managers and partners to increase revenues,
profits and number of clients. Major firms have used their weight
to intimidate audit clients in an effort to win consultancy work.
Angered by a client who decided to use the services of an independent
consultancy company to value its brands for accounting purposes,
the audit firm threatened the client suggesting that audit costs
would rise if the independent consultancy company was used in
preference to the firm's consultancy division (Accountancy Age,
14 February 1991, p 1 and 17; Accountancy, March 1991, p 11).
The consultancy company complained to the ICAEW by arguing that
"We find attempts to cajole clients into using consultancy
services by threat of `problems' exceptionally seedy and unpleasant"
(Accountancy Age, 14 February 1991, p 17). Naturally, the ICAEW
did not take any action. A myth promoted by the accountancy industry
is that the purchase of auditing and non-auditing services from
the same firm somehow results in lower costs. Such myths are not
supported by research (Simunic, 1980) which shows that when management
invite competitive tenders, shop around and purchase auditing
and non-auditing services from two separate firms, they get a
lower price. Besides, by acting as consultants auditors end up
auditing the transactions and controls which they themselves have
created and violates their independence.
Accountancy firms are desperately keen to win business (Accountancy,
June 1991, p 1). Lowballing is rife, with the big firms sometimes
undercutting the medium-sized firms by as much as a third (Accountancy
Age, 9 May 1991, p 1; Accountancy Age, 23 May 1991, p 1; Accountancy
Age, 9 January 1992, p 1). Audits continue to be used as loss-leaders
to secure non-auditing work (Accountancy Age, 6 June 1991, pp
1 and 4). Some firms have been offering free audits in the hope
of picking up lucrative consultancy work (Accountancy Age, 20
June 1991, 1; Accountancy Age, 24 October 1991, p 1). As audit
quality is not visible to the public, nor effectively monitored
by an independent regulatory agency, poor work only comes to the
surface when an inquiry follows a company collapse/fraud or some
investigative journalist pursues a story.
Faced with competition, competitive tendering and lowballing,
firm partners and senior managers are assigned income generation
targets. Those successfully negotiating the pressures are rewarded
with status, bonuses and other rewards. To maximise profits, firms
impose tight time budgets on audit staff even though time constraints
have played a major part in audit failures and incompleteness
of audit work (Department of Trade and Industry, 1995). However,
the time budgets are squeezed in the hope that audit teams would
work free on evenings and week-ends to finish the work (for examples
see Accountancy Age, 24 March 1994, p 1; Accountancy Age, 24 March
1994, p 1; The Times, 2 November 1995, p 30). Fearful of retaining
their jobs and study leave, some oblige, but large numbers of
audit trainees either use short-cuts, irregular practices or resort
to falsification of audit working papers (Otley and Pierce, 1996).
A survey by Willett and Page (1996) found that due to time pressures
large proportion of audit staff rejected awkward looking items,
accepted doubtful audit evidence, failed to test the required
number of items in a sample, or simply falsified the audit working
papers to give the impression that the work has been. Such practices
were carried out by senior and junior members of the audit teams.
As the audit review process cannot completely re-perform the audit,
irregular audit practices rarely come to light.
The DTI report on Rotaprint noted that "[Arthur Young's]
audit team was composed of relatively inexperienced trainees led
on a day-to-day basis by an unqualified senior" (DTI, 1991).
Commenting upon audit failures at the Milford Docks Company, the
inspectors noted that "neither Mr Jones nor Mr Harrison [Cooper
& Lybrand partners] should have played a major role in compiling
the report" (DTI, 1992). The DTI report on the collapse of
London united Investment concluded that "It was a mistake
by KPMG not to have obtained third party confirmations . . . it
was a conscious decision by KPMG not to obtain third party confirmations
. . .. We disagree with this decision" (DTI, 1993a). The
report accused the partners of behaving in an unprofessional way.
The DTI report on Edencorp concluded that "Ernst & Young
as auditors of the group signed an unqualified audit report on
Edencorp's 1989 group accounts without apparently considering
the accounting implications of the significant invoice issued
. . . We are therefore surprised that the accounting treatment
adopted for the transaction was given so little attention by the
finance director and auditors" (DTI, 1993b).
In an environment of tight time budgets, competition and
pursuit of higher profits, auditing firms look for ways of achieving
efficiency. One of the common practices is to use checklists for
controlling, planning and recording an audit. Such devices standardise
audits and also make the process much more mechanical, predictable
and possibly boring. The checklist mentality encourages irregular
practices. In a radio programme (BBC Radio 4—File on Four,
9 (October 2001), an auditor with 10 years experience said,
"If you pitch for an audit of certain value, obviously
you have to try and do it within that price, so you skip lots
of corners. I mean, you've got lots of checklists to fill in—have
you seen this? You just end up ticking "yes I've seen this,
I've seen this", even though you haven't ... So you end up
with piles of checklists on your audit working papers, which basically
are a complete fabrication, because you actually haven't done
the work. It's so easy to just sit there and fill in checklists,
even back in your hotel room, not even at the client's premises,
just so that when the partner rings up the next morning and says,
"I hope you're at least three quarters of the way through
the audit", you can say, "Yes, I am". The public
doesn't know what an auditor actually does. They don't know the
mechanics of an audit, so they are not aware of how much work
has actually gone on to verify and authenticate the figures in
the accounts. If the public were aware of, you know, sometimes
how little work goes on, I think they'd be quite surprised and
would be less inclined to take a clean audit report as being gospel
that the accounts are actually accurate."
In folklore, final audit opinion should be based upon the
audit evidence collected and evaluated. However, in practice the
economic interests of auditing firms, including the desire to
sell non-auditing services, often prevail. According to an auditor,
"There can be various times when you'd want to qualify
an audit, when you are not happy with things. The partners or
partner responsible would be less inclined than yourself to qualify
the report, mainly because they want the continuing business,
or they already have a relationship with the client, or to keep
the client on board, because there's other aspects to the job
as well, not just the audit. There's also the accounts, all the
directors' tax returns, there might be a lot of tax planning and
financial planning services going on as well, and management consultancy.
All those sort of things are being provided to the client, which
really ruins any independence you've got as far as being an auditor
is concerned, because of all the background services that are
also being provided. So there's enormous pressure not to qualify
the report, because you don't want to lose the client.
[An example] The client was being very uncooperative indeed
about stock, wouldn't give us any stock records or stock level,
and indicated that cooperation would only be given once he was
aware of what our draft profit figures were. I told the partner
that this was unacceptable and really we should qualify the report.
However, the partner and the client were friends and, following
a, I suspect a dinner or a drink or whatever, I was informed by
the partner that this particular stock figure had been agreed
and that there would be no qualification on the report. I have
to say I was very unhappy about that, because it was obvious that
the figure couldn't be validated in any way. [Reporter: So they
just went out to dinner together and cooked the books?]. Yes,
you could say that. They basically agreed a figure which was put
in the accounts, and the audit was signed off . . . In a sense
they're defrauding anyone that's lent money to them, you know,
their bankers, obviously the creditors, people doing business
with them. Obviously also the Inland Revenue. If the tax liability
is based on the accounts and those accounts are incorrect—for
whatever reason—the correct liability is not being collected"
(BBC Radio 4—File on Four, 9 October 2001).
The commercial considerations have persuaded auditing firms
to remain silent about questionable clients. For example, in January
1990 BBCI pled guilty to charges of money laundering (United Stated,
Senate Committee on Foreign Relations, 1992, p 61), but this did
not prompt its auditors, Price Waterhouse, to resign or qualify
the accounts.
In pursuit of fees, accountancy firms also accept clients
with "danger" written all over them. For example, Coopers
& Lybrand (now part of PricewaterhouseCoopers) accepted Robert
Maxwell as a client even though he had previously been described
as a person "who cannot be relied upon to exercise proper
stewardship of a publicly-quoted company" (Department of
Trade and Industry, 1973, 1972, 1971b). From 1972 (almost a year
before the publication of the final damning DTI report) Coopers
& Lybrand became auditors and business advisers to most of
the Maxwell controlled companies and pensions funds. The auditors
valued assets of the Maxwell business and then reported on the
reasonableness of the same. Maxwell (committed suicide in November
1991) systematically plundered the pension funds to the tune of
£458 million (House of Commons Social Security Committee,
1992). Some parts of the Maxwell empire did not keep proper accounting
records but auditors continued to issue unqualified audit reports.
The DTI inspectors' report showed that the relationship between
the audit firm and Maxwell was close. The appeasement of Maxwell
was a major priority for the audit team (Department of Trade and
Industry, 2001).
Some auditing aspects of the Maxwell debacle were examined
by the Joint Disciplinary Scheme (JDS). Its report (Joint Disciplinary
Scheme, 1999) concluded that the audit firm "lost the plot",
"got too close to see what was going on" and "failed
to consider whether there was evidence of fraud, other irregularities,
defaults or other unlawful acts" (The Times, 3 February
1999, p 21; Bower, 1999; Financial Times, 3 February 1999,
p 10; The Observer Business, 7 February 1999, p 6; Daily
Mail, 27 May 1999, p 5). The audit firm and its partners admitted
57 errors of judgement, including inadequate work, incompetent
performance, undue acceptance of management representations, deficient
consideration of the interest of third parties and deficient partner
review[32] (Chitty, 1999).
Despite rules and regulations about auditor training, one of the
partners claimed that he had never encountered fraud before. In
response, the JDS individualised audit failures. Rather conveniently,
most of the blame was allocated to the Coopers & Lybrand audit
partner Peter Walsh, who died (in 1996) whilst the JDS was making
its inquiries. The JDS did not investigate the organisational
practices and values of the audit firm.
Walking Quietly
Auditing firms have a history of "disclosing considerably
less than what they actually know" (Woolf, 1986, p 511).
Such suspicions are further supported by the practices of resigning
auditors. Since the UK's Companies Act 1976 (now consolidated
into the Companies Act 1985), resigning auditors have been required
to make public statements, addressed to shareholders and creditors
of companies, to draw attention to the circumstances, if any,
of their resignation.
Section 394(1) of the Companies Act 1985 states that "Where
an auditor ceases for any reason to hold office, he shall deposit
at the company's registered office a statement of any circumstances
connected with his ceasing to hold office which he considers should
be brought to the attention of the members or creditors of the
company, or if he considers that there are no such circumstances,
a statement that there are none". Such legal requirements
were developed in the aftermath of corporate collapses and scandals
where the silence of the auditors was considered to be detrimental
to the interests of the stakeholders (Dunn and Sikka, 1998).
The legislation was introduced in the aftermath of the frauds
at Pinnock Finance Group (DTI, 1971a) where the "asset figures
in the balance sheets were not merely unrealistic but blatantly
false" (p 249). The auditors were described as "tame
and negligent" and decided to walk away quietly. The provisions
of the Companies Act 1976 were designed to "strengthen the
position of auditors" (Hansard, House of Lords Debates, 23
March 1976, col 550), and particularly "strengthen the hand
of the weaker brethren" (Hansard, House of Lords Debates,
23 March 1976, col 578). The legislation is accompanied by immunities
from "libel" [33]
and the hope that it will "give a strong auditor a very powerful
and effective threat in the event of a dispute with the directors
and will force even a weak auditor to face up to his responsibilities
as he will no longer be able to evade a difficult situation by
quietly resigning and saying nothing" (Hansard, House of
Lords Debates, 23 March 1976, cols 554-555).
Despite a proliferation of auditing standards, ethical statements
and regulation, auditors seem reluctant and/or unwilling to discharge
their obligations (Dunn and Sikka, 1999). For example, consider
the case of the Queens Moat Houses Plc, once the third largest
hotel chain in the UK. Through an aggressive acquisition policy,
it expanded and its profits grew from £24.8 million in 1987
to £94.1 million in 1990. The company's accounts carried
unqualified audit reports until 1991. In 1993, just a week before
its 1992 financial statements were to be published, the company
asked (on 31 March 1993) the London Stock Exchange to suspend
trading of its shares (The Times, 1 April 1993, p 23).
Major banks were asked to devise a financial package to rescue
the company (The Times, 8 April 1993, p 25). Grant Thornton
were asked to investigate the company's affairs. This investigation
revealed (April 1993) that the company was likely to report a
substantial loss (The Observer, 23 May 1993, p 30). A large
number of directors either resigned or left.
Amidst these events, on 18 May 1993, Queens Moat Houses auditors,
Messrs Bird Luckin, resigned and stated,
"we confirm that there are no circumstances connected
with our resignation which we consider should be brought to the
notice of the members or creditors of Queens Moat Houses plc".
The company's financial statements for the year to 31 December
1992 were finally published on 29 October 1993. In it, the 1991
pre-tax profit of £90.4 million was restated as a loss of
£56.3 million. The £146.7 million difference included
£50.9 million of depreciation that the group had not previously
provided for and maintenance expenditure which had been capitalised.
Other changes related to overstatement of profits on fixed sales,
expenses which had been capitalised and misclassification of finance
leases. Whilst analysts were predicting a profit of some £90
million for 1992, the actual published accounts revealed that
the company made a pre-tax loss of £1.04 billion. Much of
it was due to exceptional items and a write-down of property values.
The 1992 balance sheet showed net debt to be £1.17 billion
and a negative net worth of £388.9 million.
For the two previous years the company had been operating
with virtually no financial controls (Financial Times, 30-31
October 1993, p 8). It was alleged that the company had paid unlawful
dividends for 1991, 1992 and 1993 (Financial Times, 30-31
October 1993, p 1; The Observer, 31 October 1993, p 2).
The finance director's report explained that "there were
no monthly consolidated management accounts to enable the board
to monitor the progress of the group". In particular there
were minimal group cash forecasts and no clearly defined treasury
function. It was reported that one of the company's directors
was a former partner of the audit firm.
On 12 November 1993, the Department of Trade and Industry
appointed inspectors under section 432 of the Companies Act 1985
to investigate the affairs of the company. A report is yet to
be published.
Take another example of MTM Plc, which through an aggressive
acquisitions policy became the second largest fine chemicals company
in the UK. In 1992, it collapsed with debts of £250 million
(The Independent, 4 February 1997, p 16). The Company had
issued two profit warnings and its share price plummeted from
286 pence to 26 pence (Financial Times, 1 May 1992, p 20).
There were considerable disagreements between auditors, BDO Binder
Hamlyn, and the Board and the announcement of the 1991 financial
results was delayed. Richard Lines, MTM's chairman and founder,
resigned early in March 1992 over disagreement with the auditors
"over application of accounting policy" (Financial
Times, 11 March 1992, p 11). An internal report prepared by
auditors BDO Binder Hamlyn suggested that the company boosted
its 1991 (and also in earlier years) sales and profits by "incorrectly
recorded" transactions (Financial Times, 14 May 1992,
p 22). In May 1992, it was reported that MTM was "co-operating
fully with the SFO [Serious Fraud Office] and the North Yorkshire
police in an investigation being carried out concerning matters
relating to that shortfall" (Financial Times, 14 May
1992, p 22).
MTM's auditors, BDO Binder Hamlyn, gave an unqualified audit
opinion (dated 5 June 1992) on the financial statements for the
year to 31 December 1991. On 8 September 1992 they resigned and
stated that:—
"There are no circumstances connected with our resignation
which we consider should be brought to the attention of the members
or creditors of the company".
The very next day, the company announced an interim loss
of £28 million and its new chief executive claimed that the
previous year's accounts were materially overstated (Financial
Times, 10 September 1992, p 20). The new chief executive sought
to restructure the company and looked for a substantial cash injection
(Financial Times, 10 September 1992, p 20).
Price Waterhouse took over the audit. The firm's first audit
report, dated 28 April 1993, related to the financial statements
for the year to 31 December 1992. It referred to the fact that
"the company is co-operating with the Serious Fraud Office
and the North Yorkshire Police in relation to an investigation
being carried out concerning matters relating to the profit shortfall
announced in the 1991 Reports and Accounts . . .".
The SFO inquiries continued in 1993 (Financial Times,
10 April 1993, p 10) and in 1994. Richard Lines and Thomas
Baxter, another former MTM director, were formally charged with
false accounting, conspiracy to commit false accounting or furnish
false information, and making false and misleading statements
under the Financial Services Act. It was alleged that they recorded
bogus transactions for 1990 and 1991 in order to meet profit forecasts.
According to the prosecuting QC, the directors, "assisted
by others, cooked the books, in order to give the impression that
the company was a good deal more profitable that was, in fact,
the case" (Financial Times, 4 February 1997, p 12).
Amongst other things directors sold company's plant and machinery
to a supplier for a profit of £700,000 with an agreement
to repurchase the assets so that there was no net cost to the
supplier. Both former directors were convicted of fraud and Richard
Lines was sentenced to two years imprisonment and Thomas Baxter
to six months (Serious Fraud Office Report, 1996-97). In relation
to the auditors, the judge said, "It may be that BDO had
become far too cosy with MTM" (Financial Times, 4
February 1997, p 12).
We don't like Talking
The history of auditing draws attention to the organisational
practices of auditing firms and their potential to do material
harm to people. Woolf (1983) draws attention to audit failures
that show "the ease with which eminent firms of auditors
turned a blind eye on the wholesale abuse by client company directors
of [legal] provisions. [The directors] operated these public companies
for the principal benefit of themselves and their families; and
most regrettable of all, on the virtual complicity of their auditors,
whose efforts are seen to have amounted to a whitewash at best,
and a fatuous charade at worst". In response, without any
investigation of the organisational practices of accountancy firms
or the their lack of accountability that gives rise to audit failures,
the UK government has strengthened the statutory rights and powers
of auditors.
Ever since the Companies Act 1948 (Section 160), auditors
have been empowered to speak at all Annual General Meetings (AGM)
and express their concerns about anything relating to financial
statements. However, auditors appear to be more concerned to appease
company directors, their effective paymasters. Consider the case
of Ramor Plc, a company audited by Price Waterhouse (now PricewaterhouseCoopers).
To prepare for the possibility that someone attending the AGM
might ask searching and unwelcome questions, the auditors reached
a prior agreement with the company to be "economical with
information", as evidenced by a letter exchanged between
the chairman of the company (Mr Smith) and the Price Waterhouse
audit partner (Peter Ainger). The letter said (Department of Trade
and Industry, 1983, p 283),
Dear Mr Smith,
As arranged I am writing to let you know in advance of the
Annual General Meeting on 26 July the replies I will give if I
am asked by a shareholder for the reasons why my firm is not seeking
re-election as auditors. If no questions are asked, then of course,
no further information in addition to that contained in the Annual
Report need be provided.
However, if a shareholder asks further information I propose
to reply as follows:
"In recent years we have experienced certain difficulties
in obtaining necessary information for our audit and being sure
that all relevant explanation have been provided to us. In the
final outcome we have been satisfied that we have received all
such information and explanation; otherwise this would have been
reflected in our audit report. However the situation created by
these difficulties caused us to agree with the directors that
we would not seek re-election at this meeting, a step we are permitted
to take under the provisions of the Companies Act."
If there should be a follow-up question asking for more information
about the difficulties referred to in the foregoing statement
I would propose to reply as follows:
"There was no one matter which in itself caused us to
reach this agreement with the directors. In view of this, there
is nothing more that can be added to the answer that has already
been given.
I would not intend to give any more information nor to respond
to any other question".
Following allegations of frauds, the Department of Trade
and Industry appointed inspectors (Department of Trade and Industry,
1983). The interim report[34]
of the inspectors concluded that:
— "Price Waterhouse's conduct as regards the
non-executive directors and incoming auditors is indefensible"
(p 286).
— "Price Waterhouse's acceptance of the position
and of the manipulation is both surprising and disturbing"
(p 79).
— "at the AGM itself Mr Ainger Price Waterhouse
partner despite having notice of . . . questions, answered them
in terms which gave the shareholders less than the full picture
and conveyed an impression of certainty . . . which was not justified"
(p 278)
— ". . . we have no hesitation . . . and have
no doubt that Price Waterhouse attempted to play down the situation"
(p 285).
The DTI inspectors criticised Price Waterhouse for resigning
the audit and going too quietly (Department of Trade and Industry,
1983, chapter 14). The public face was that "By mutual agreement
our Auditors Price Waterhouse and Co are not seeking re-election
. . ." (DTI, 1983, p 283), but the inspectors concluded,
"there was nothing mutual in Price Waterhouse's decision
to go" (p 284).
Auditing firms seem to be more concerned about protecting
their flow of profits than answering questions about their own
and corporate conduct, which could arguably enable some to manage
their risks and call organisations to account.
STRUCTURAL AND
CULTURAL PROBLEMS
In pursuit of profits, accountancy firms have long been using
audits as a market stall to sell non-auditing services (Accountancy,
June 1995, p 13; Mitchell and Sikka, 1993). Unlike other auditors
(eg Inland Revenue, Customs and Excise, Health and Safety Executive),
financial auditors hire company directors, value assets, create
business transactions, internal control systems, accounting systems,
perform internal audit functions and then claim that they can
somehow audit the same without any detrimental effect on their
independence.
Rather than ensuring that auditors act exclusively as auditors,
the regulators support the auditing industry. They spread false
information. For example ICAEW Deputy President and PwC partner,
Peter Wyman, claimed that "Independent investigations have
not shown the provision of consulting services to have been the
cause, or even a contributory cause, to any audit failure[35]".
(Financial Times, 21 January 2002, p 14).
Auditors of Roadships were criticised for their failure to
adequately check the amounts for creditors, accruals, purchase
and profit forecasts (DoT, 1976a). The audits were not independent
as auditors acted as consultants for the company. The inspectors
(one of whom is usually a partner from a major accountancy firm)
argued that:
"Independence is essential to enable auditors to retain
that objectivity which enables their work to be relied upon by
outsiders. It may be destroyed in many ways but significantly
in three; firstly, by the auditors having a financial interest
in the company; secondly, by the auditors being controlled in
the broadest sense by the company; and thirdly, if the work which
is being audited is in fact work which has been done previously
by the auditors themselves acting as accountants" (para 243).
After examining the quality of audits performed by auditors
who also provided non-auditing services, the inspectors concluded:
"We do not accept that there can be the requisite degree
of watchfulness where a man is checking either his own figures
or those of a colleague. . . for these reasons we do not believe
that [the auditors] ever achieved the standard of independence
necessary for a wholly objective audit" (paras 249 and 250).
The DTI report on Hartley Baird found that the company was
having difficulties in repaying loans. But the financial problems
were covered-up by manipulation of the account. The report stated
that the auditors were ineffective because of their close connections
with company directors and suggested rotation of auditors (DTI,
1976b).
The Department of Trade and Industry (DTI) inspectors' report
on Burnholme and Forder (DTI, 1979a) was critical of audit work
and once again felt that auditor independence was compromised
by the provision of non-auditing services to audit clients. They
concluded:
"in our view the principle of the auditor first compiling
and then reporting upon a profit forecast is not considered to
be a good practice for it may impair their ability to view the
forecast objectively and must endanger the degree of independence
essential to this work" (p 271).
In 1978, the collapse of the Grays Building Society reminded
people of the ineffectiveness of external auditors. The resulting
investigation (Registry of Friendly Societies, 1979) found that
the same firm had been auditing the building society for nearly
forty years. Its partners became friends of directors and frequently
took holidays together. The auditors failed to perform the simplest
of checks and did not spot frauds of more than £7.1 million,
carried out over a period of some forty years. The frauds only
came to light when the chairman committed suicide. The report
was highly critical of auditors and noted that their "independence"
had been compromised by the longevity of their term in office
and the personal relationships with company directors which had
developed as a consequence.
The report on Kina Holdings (DTI, 1981a) criticised auditors
and noted that the same firm had been providing auditing and non-auditing
services to a major quoted company for a number of years. This
relationship resulted in a considerable part of the firm fee income
coming from one client and created difficulties with perceived
independence of auditors.
Audit failures continue to raise questions about auditor
independence. For
example, Stoy Hayward acted as auditors and consultants to Polly
Peck for a period of fifteen years. The firm always issued unqualified
audit opinions.
The House of Commons Select Committee on Social Security
recommended that pension fund auditors should not be allowed to
carry out non-auditing services for their audit client (Accountancy
Age, 12 March 1992, p 1; Accountancy, April 1992, p
18). Such recommendations followed consideration of frauds perpetrated
by Robert Maxwell, an episode which once again raised questions
about the desirability of auditors auditing the balance sheet
figures that they themselves had created. In 1991, the Maxwell
Group of Newspapers was floated with £625 million value attaching
to newpaper titles in the balance sheet. The titles made up a
bulk of the shareholders' funds shown at £840 million. The
valuation of the titles was undertaken by Coopers & Lybrand
who also audited the accounts and reported on, the flotation prospectus.
The same firm had been auditing Maxwell businesses for the last
twenty years without ever issuing a qualified audit opinion.
The issue of conflict of interest is again raised by the
case of BCCI, a fraud infested bank that had been forcibly closed
down (US Senate, 1992). In this Price Waterhouse simultaneously
acted as auditor, eyes and ears of the regulators and advisers
to BCCI management. BCCI bank hired the Consultancy Division of
its auditors, Price Waterhouse (UK), to tackle losses from its
treasury operations. The consultants completed their work in 1986
and the auditors [Price Waterhouse] reported that they were satisfied
and that their recommendations for improving Treasury controls
had been implemented. As a result of its review of the Treasury
operations in 1985, the auditors also discovered a potential tax
liability to the UK government, and subsequently advised BCCI
to move its Treasury operations out of the United Kingdom to avoid
payment (Arnold and Sikka, 2001). In Price Waterhouse's words,
"In our report dated 28 April 1986, we referred to the
control weaknesses which existed in respect of the group's Central
Treasury Division ("Treasury"). During 1986 management
engaged the services of the Consultancy Division of Price Waterhouse,
London, to assist them in implementing recommendations contained
in our earlier report. We reviewed the progress made by the bank
on the implementation of revised procedures during the year and
in a report dated 5 August 1986 we were able to conclude that
most of our significant recommendations had been implemented.
A further feature arising from the review of Treasury operations
in 1985 was the potential liability to UK Corporation Tax arising
from the Division's activities in the period 1982-85. Following
advice from ourselves and from the Tax Counsel during 1986 it
was determined that this liability could be significantly reduced
if the Bank ceased trading in the United Kingdom and claimed a
terminal loss". (US Senate, 1992, p 175).
BCCI's Treasury was moved from London to Abu Dhabi in 1986
with Price Waterhouse assisting with the transfer. The audit firm
was simultaneously acted as private consultants and advisors to
BCCI management to further their "private" interests.
Yet at the same time the state was expecting them to perform "public
interest" functions by acting as an external monitor and
quasi-regulator[36].
After the closure of BCCI (in July 1991), investigations into
BCCI's criminality have been hampered by the fact some crucial
documents had been transferred from London to Abu Dhabi.
The relationship between the management of BCCI and its auditors
was so close that the US Senate concluded that "there can
be no question that the auditing process failed to work"
(US Senate, 1992, p 253). The US senate Report also noted that.
"BCCI provided loans and financial benefits to some of
its auditors, whose acceptance of these benefits creates an appearance
of impropriety, based on the possibility that such benefits could
in theory affect the independent judgement of the auditors involved.
These benefits include loans to two Price Waterhouse partnerships
in the Caribbean. In addition, there are serious questions concerning
the acceptance of payments and possibly housing from BCCI or its
affiliates by Price Waterhouse partners in the Grand Caymans,
and possible sexual favors provided by BCCI officials to certain
persons affiliated with the firm" (United States Senate Committee
on Foreign Relations 1992b, pp 4-5)"
The typical response to any revelations about the audit firm
conflicts of interests is to call for more professional pronouncements
and ethical rules rather than statutory rules and independent
enforcement mechanisms. However, in pursuit of profits accountancy
firms are rarely constrained by any codes of conduct or ethical
statements issued by the accountancy trade associations (Mitchell
et al., 1994).
The DTI inspectors' report on Aveley Laboratories Limited
(DTI, 1981b) noted that in pursuit of fees, the audit firm showed
no regard to the ethical guidelines issued by the accountancy
trade associations. Auditors were criticised for conflicts of
interests arising out of the acceptance of the office of the receiver
for their former clients. Conflicts of interests arising from
financial relationship with the company and its directors also
drew critical comments from the DTI inspectors' report on Scotia
Investments Limited (DTI, 1981c). Yet the issues were to be repeated
again.
Coopers & Lybrand (now part of PricewaterhouseCoopers)
violated the so called "ethical" rules to secure the
lucrative administration, receivership and liquidation of Polly
Peck, a company with whom they had previous and on-going links
(Mitchell et al., 1994). The ethical guidelines of the
profession stated that firms should not accept such a position
where "there is a continuing professional relationship"
with the client. In accepting the position of the administrator,
Coopers did not reveal its prior relationship with Polly Peck
and its Chairman. The firm had acted as joint reporting accountants
when Polly Peck originally went public; it had consultancy links
with the company; advised the company chairman; played a role
in the appointment of the company's finance directors and it had
audited Polly Peck's Far East operations. After two years of public
ridicule, the ICAEW found the partners guilty of violating the
guidelines. The punishment for guilty partners was a fine of £1000
(maximum possible) whilst the firm is estimated to have made around
£30 million from its insolvency assignment.
In pursuit of profits, accountancy firms continue to have
deep organisational and cultural problems in complying with the
rules. Some support for this view is provided by an investigation
by the Securities Exchange Commission (SEC). On 4 January 1999,
the US regulator, the SEC, censured PricewaterhouseCoopers (PwC)
for "violating auditor independence rules and improper profession
conduct" (SEC press release, 6 January 2000) and ordered
an internal review of PwC's compliance with the rules of auditor
independence. As part of the review, PwC staff and partners were
asked to self-report independence violations, and the independent
reviewers were asked to randomly test a sample of the responses
for completeness and accuracy. The review revealed more than 8,000
violations, including those from partners responsible for overseeing
and preventing violations. The report concluded that there was.
"widespread Independence non-compliance at PwC despite
clear warnings that the SEC was overseeing 77.5 per cent of partners
and 8.5 per cent non-partners selected for audit in the Random
Sample Study failed to report at least one violation. Many of
the partners had substantial number of previously unreported violations.
A total of approximately 86.5 per cent of partners and 10.5 per
cent of non-partners in the Random Sample Study had at least one
reported or unreported Independence violation. These results suggest
that a far greater percentage of individuals in PwC's firmwide
population had Independence violations than was revealed by the
self-reporting process. The number of violations reflected serious
structural and cultural problems (emphasis added) that were rooted
in both its legacy firms (Price Waterhouse and Coopers & Lybrand
merged to form PwC)" (Securities Exchange Commission, 2000,
pp 122-123)."
PwC is not alone in having serious structural and cultural
problems. In June 2000, the SEC started a "look back"
program and required major accounting firms to review their independence
procedures and violations (SEC press release, 7 June 2000). As
part of this, KPMG was admonished (SEC press release, 14 January
2002). The findings showed that contrary to the "independence"
rules, KPMG had a substantial investment in Short-Term Investment
Trust (STIT), part of the AIM Funds, a collection of mutual funds
audited by the firm. After the initial investment of $25 million,
KPMG made 11 additional investments and by September 2000, its
investment constituted some 15 per cent of the STIT's net assets.
The audit firm issued reports stating that it was "not aware
of any relationships between (KPMG) and the (AIM) Funds that,
in our professional judgement, may reasonably be thought to bear
on our independence".
The violation of the auditor independence rules was highlighted
by third parties, as KPMG did not have the necessary organisational
procedures. As the SEC put it,
"KPMG lacked adequate policies and procedures designed
to prevent and detect independence problems caused by investment
of the firm's surplus cash. The failure constituted an extreme
departure from the standards of ordinary care, and resulted in
violations the auditor independence requirements imposed by the
Commission's rules" (SEC press release, 14 January 2002,
p 6).
In principle, there is possibility that an understanding
of the context of audit failures may be enhanced by investigation
of the files of accountancy firms. However, as the next part shows
the affairs of accountancy firms are organised in such a way that
they obstruct investigations by regulators.
ORGANISED NON-COOPERATION
Accountancy firms have been in the vanguard of globalisation.
Increasingly, they secure audits of major corporations by parading
their "global" credentials (US Senate, 1992). With the
aid of private sector organisations, such as the International
Accounting Standards Board (IASB) and the International Auditing
Practices Committee (IAPC), the firms have sought to develop standards
and pronouncements that might reduce their training costs, dilute
liabilities and hence increase profits. The same vigour appears
to be missing in developing organisational structures that would
enhance accountability or require accountancy firms to co-operate
with local/global regulators. Four examples illustrate the arguments.
These relate to US$10 billion frauds resulting in the closure
of the Bank of Credit and Commerce International (BCCI), audit
failures at Barings and US$1 billion at International Signal and
Control Group, part of Ferranti plc, a major UK defence contractor.
In July 1991, amidst allegations of fraud, the Bank of England
closed down the Bank of Credit and Commerce International (BCCI),
considered to be the "world's biggest fraud" (Killick,
1998, p 151). At the time of its closure, BCCI operated from 73
countries and had some 1.4 million depositors. Whilst there has
been no independent investigation of the real/alleged audit failures
in the UK, an inquiry by the US Senate concluded that "Regardless
of the BCCI's attempts to hide its frauds from its outside auditors,
there were numerous warning bells visible to the auditors from
the early years of the bank's activities, and BCCI's auditors
could have and should have done more to respond to them. The certification
by BCCI's auditors that its picture of BCCI's books were "true
and fair" from 21 December, 1987 forward, had the consequence
of assisting BCCI in misleading depositors, regulators, investigators,
and other financial institutions as to BCCI's true financial position"[37]
(US Senate, 1992, p 4).
An examination of the working papers and files of the BCCI's
auditors, Price Waterhouse (PW), had a considerable potential
to provide public information about the organisational practice
of auditing firms. It could also have provided some pointer for
possible reforms. The US Senate sought access to auditor files.
Despite claiming to be a "global firm" Price Waterhouse
remained reluctant to co-operate with international regulators.
An investigation of BCCI by New York state banking authorities
was also frustrated by the auditors' lack of co-operation. The
New York District Attorney told the Congress that
"The main audit of BCCI was done by Price Waterhouse
UK. They are not permitted, under English law, to disclose, at
least they say that, to disclose the results of that audit, without
authorization from the Bank of England. The Bank of England, so
far—and we've met with them here and over there—have
not given that permission.
The audit of BCCI, financial statement, profit and loss balance
sheet that was filed in the State of New York was certified by
Price Waterhouse Luxemborg. When we asked Price Waterhouse US
for the records to support that, they said, oh, we don't have
those, that's Price Waterhouse UK.
We said, can you get them for us? They said, oh, no that's
a separate entity owned by Price Waterhouse Worldwide, based in
Bermuda." (US Senate 1992, p 245)
BCCI's auditors also refused to co-operate with the US Senate
Subcommittee's investigation[38]
of the bank (US Senate 1992, p 256). Although the BCCI audit was
secured by arguing that Price Waterhouse was a globally integrated
firm (US Senate, 1992, p 258), in the face of a critical inquiry,
the claims of global integration dissolved. Price Waterhouse (US)
denied any knowledge of, or responsibility for the BCCI audit
which it claimed was the responsibility of Price Waterhouse (UK).
Price Waterhouse (UK) refused to comply with US Senate subpoenas
for sight of its working papers and declined to testify before
the Senate Subcommittee on the grounds that the audit records
were protected by British banking laws, and that "the British
partnership of Price Waterhouse did not do business in the United
States and could not be reached by subpoena" (p 256). In
a letter dated 17 October, Price Waterhouse (US) explained that
the firm's international practice rested upon loose agreements
among separate and autonomous firms subject only to the local
laws:
"The 26 Price Waterhouse firms practice, directly or
through affiliated Price Waterhouse firms, in more than 90 countries
throughout the world. Price Waterhouse firms are separate and
independent legal entities whose activities are subject to the
laws and professional obligations of the country in which they
practice. . ..
No partner of PW-US is a partner of the Price Waterhouse firm
in the United Kingdom; each firm elects its own senior partners;
neither firm controls the other; each firm separately determines
to hire and terminate its own professional and administrative
staff . . . each firm has its own clients; the firms do not share
in each other's revenues or assets; and each separately maintains
possession, custody and control over its own books and records,
including work papers. The same independent and autonomous relationship
exists between PW-US and the Price Waterhouse firms with practices
in Luxembourg and Grand Cayman" (US Senate, 1992, p 257).
Accountancy firms have no difficulty in making claims of
being "global" to win business. But in the face of questions
about accountability such claims are easily dissolved. The same
is encountered in other episodes as well. Enron is known as the
world's biggest bankruptcy. The US authorities have alleged that
the London Offices of auditors, Arthur Andersen' shredded key
documents to escape prosecution. In response to lawsuits and request
for documents, the firm is now saying that Arthur Andersen is
not global. An official statement said that "Arthur Andersen
LLP [the US firm], an autonomous member firm of the Andersen Worldwide
SC organisation, contracted with, performed the audits of, and
signed the audit opinions on Enron's financial statements. Accordingly,
Arthur Andersen LLP is the only proper defendant in claims relating
to that audit opinion". John Ormerod, managing partner of
Andersen in the UK, said: "Naming our firm as a defendant
has no legal basis. While we have sympathy for those affected
by Enron's failure, Andersen in the UK has no obligation to satisfy
the legal liabilities of other member firms." [39]
The third example looks at Barings. On 26 February 1995,
amidst revelations of £827 million frauds, Barings Plc collapsed
(Bank of England, 1995). For many years prior to the collapse,
Barings had been audited by Coopers & Lybrand (C & L).
The Singapore office of C & L was appointed to audit the affairs
of Baring Futures (Singapore) Pte Limited (BFS) for the year to
31st December 1994. The 1992 and 1993 accounts of BFS were audited
by the Singapore office of Deloitte & Touche (D & T) who
reported to C & L London for the purposes of its audit of
the consolidated financial statements of Barings plc C & L
audited all other subsidiaries of Barings in 1992, 1993 and 1994
either through its London office or other offices spread around
the world. As part of its inquiry, the Bank of England (BoE) sought
access to the auditor files but the audit firms did not cooperate
The BoE noted,
"We have not been permitted access to C & L Singapore's
work papers relating to the 1994 audit of BFS (Baring Futures
(Singapore) Pte Limited) or had the opportunity to interview their
personnel. C & L Singapore has decline our request for access,
stating that its obligation to respect its client confidentiality
prevents it assisting us" (Bank of England, 1995, p 15).
"We have not been permitted either access to the working
papers of D&T or the opportunity to interview any of their
personnel who performed the audit. We do not know what records
and explanations were provided by BFS personnel to them"
(Bank of England, 1995, p 153).
The organisational structures and practices of accountancy
firms also came under scrutiny in the aftermath of the financial
problems at Ferranti, caused by the US $1 billion fraud at one
of its subsidiaries, International Signal and Control Group Plc
(ISC). The company was primarily engaged in the design and manufacture
of military equipment. In 1987, the ISC and its subsidiaries,
including a company called Technologies, were acquired by Ferranti.
Technologies had factories head office in the US and was audited
by Peat Marwick Mitchell (PMM), subsequently part of KPMG. The
balance sheet of Technologies included some suspect contracts.
Over a period of time $1 billion worth of fraudulent contracts
had been placed on ISC's balance sheet. Some directors of ISC
had been engaged in a massive fraud and money laundering operation
through shell companies Panama, Switzerland and the US. The company's
directors allegedly laundered $700 million through the network
of Swiss and US bank accounts. Fictitious contracts and transactions
were created through offshore companies to boost profits. Following
an investigation in 1988, ISC's founder and director was prosecuted.
He pleaded guilty and was given a prison sentence. Ferranti bought
the company without any knowledge of the frauds and sued auditors
for negligence. An out of court settlement of £40 million
was reached.
In response to complaints, the Joint Disciplinary Scheme
(JDS), an organisation operating on behalf of the UK accountancy
trade associations, was asked to investigate the matter. It sought
sight of the audit working papers for the period 1986-89. Its
report noted that.
"It quickly became clear that a substantial part of the
audit work for Technologies had been undertaken on behalf of PMM
in London by the American firm of the same name . . . considerable
difficulties were experienced in gaining such access . . . I was
informed that it was not that firms' policy to make papers available
in situations of this kind. . .. Copies of the American firm's
working papers were eventually made available, "exceptionally
and in order to assist the investigation", at the offices
of a law firm in New York. . .. The copy files produced in New
York were inadequate for the purposes of the investigation and
it was necessary to arrange access to be gained to the original
files. I was told that these were in the possession of the US
Attorney in Philadelphia. My investigating accountant went there
to examine them. They discovered that many of the files relevant
for my purpose had remained in the possession of PMM. The firm
had considerable difficulty in locating these files. Once they
had been found a third visit to America was arranged. My investigating
accountants were not permitted to photocopy relevant material
or any of American firm's files, rendering extensive note-taking
necessary" (Joint Disciplinary Scheme, 1996, p 7).
The auditing industry and its regulators seem to be aware
of the culture of non-cooperation, but have been reluctant to
scrutinise the practices and policies that give rise to them.
REGULATING RISKS
FROM AUDITING
In market economies, auditing is regulated through a variety
of formal and informal processes. These include the education
and training of accountants, the legal environment and the formal
regulatory arrangements, often involving the state and accountancy
trade associations. However, little attention is directed at the
capacity of organisational practices and cultures of accountancy
firms to facilitate audit failures and harms to a wide variety
of people.
EDUCATION
Most of the auditing education, especially professional education,
is primarily technical in nature. Considerable attention is paid
to learning the official auditing standards and other pronouncements
without a study of the practical politics of auditing. Such studies
can show that auditing standards are often driven by the auditing
industry's concerns to minimise its responsibility and liability
(Sikka, 1992). They rarely pay any attention to the organisational
practices of accountancy firms, or open them up to public scrutiny.
Auditing education rarely focuses upon the theories underpinning
auditing knowledge, far less consider its limitations and failures
(Sikka, 1987; Puxty et al., 1994). Almost every week, newspapers
highlight new audit failures. Yet students are forced to learn
knowledge that has already explicitly failed. No questions are
raised about the domination of auditing standard setting by the
auditing industry, its patrons, its values and business interests.
The consequences of auditing knowledge and practices could be
analysed by discussing audit failures, but such matters rarely
form part of auditing education. There is rarely any discussion
of the relationships, tensions and consequences arising out of
the auditing arrangements that expect capitalist organisations
(accountancy firms) to perform social surveillance. The same pattern
continues in the post-qualification education. Thus auditing education
is neither theoretical nor practical.
LIABILITY LAWS
The law has the capacity to affect changes in organisational
practices so that the delivery of socially desirable audits and
stakeholder welfare is prioritised. It is common practice to require
producers of sweets and potato chips/crisps to owe a "duty
of care" to third parties, but the same does not apply to
producers of audit opinions. The legal position, as summed by
the Law Lords in the case of Caparo Industries plc v Dickman
and Others (1990) 1 All ER HL 568 is that, generally, auditors
only owe a "duty of care" to the company, as a legal
person. They do not owe a "duty of care" to any individual
shareholder, creditor, pension scheme members or any other stakeholder[40].
A recurring feature of the auditing industry is that the regulator
(eg the accountancy bodies) routinely campaign to demand liability
and other concessions for auditing firms (Cousins et al., 1998).
However, they rarely campaign to secure any concessions for the
audit stakeholders, or consider the consequences of their campaigns
for the institutionalisation of audit failures.
Interestingly, the government found time and resources to
enact the Limited Liability Act 2000 and grant further liability
concessions to auditing firms. However, it could not find time
or the political will to reverse the Caparo judgement.
More recently, the DTI undertook a review of corporate legislation.
As a part of this it delegated the review of auditor liability
and accountability to a working party chaired by a PwC partner.
Naturally enough, the working party opposed any change to the
liability position and did not come with a single suggestion for
making audit firms accountable to stakeholders. It failed to consider
why in the absence of a "duty of care" auditing firms
would have any economic incentives to reflect upon the negative
social consequences of their activities.
REGULATION
The overall responsibility for regulating the UK auditing
industry rests with the Department of Trade and Industry (DTI).
From time to time, it appoints inspectors to examine unexpected
corporate collapses and frauds. As part of the inquiries, the
inspectors may focus upon the conduct of company audits. The DTI
does not have an adequately resourced in-house investigation unit.
Instead, it appoints partners from major accountancy and law firms
to act as inspectors. The inspectors rarely examine the impact
of organisational culture and values on audit failures. Some of
the inspectors reports have been suppressed whilst others take
many years to publish (Sikka and Willmott, 1995b; Department of
Trade and Industry, 2001). For example, the Maxwell report appeared
some ten years after the event and the report on Queens Moat Houses
(authorised in 1993) is yet to see the light of the day. The DTI
has failed to appoint an inspector to investigate frauds at BCCI,
Polly Peck, Levitt, Resort Hotels and other cases.
By holding out the threat of punitive action, the DTI could
create the economic incentives for accountancy firms to reflect
upon the consequences of their anti-social practices. However,
it has rarely prosecuted any auditing firm or its partners for
delivering poor audits, or mounted a fuller investigation into
the organisational culture of the firms implicated in audit failures.
Since the Companies Act 1989, the accountancy bodies have
been formally empowered to act as regulators of the UK auditing
industry. As part of their regulatory obligations, they licence,
monitor and discipline auditors and also investigate instances
of real/alleged audit failures. As part of their monitoring duties,
the regulatory bodies could specifically examine the impact of
organisational practices upon audits, but they seem unwilling
or unable to scrutinise the organisational context and practice
of auditing. Instead, they claim that "the main purpose of
practice monitoring is to monitor compliance with auditing standards,
rather than to obtain statistical information about the quality
of work being done" (Page 25 of the ACCA's 1992 annual report
on Audit Regulation) and that the "principal purpose of monitoring
is to enable the ARC's (Audit Registration Committees) to satisfy
themselves that registered auditors comply with the Audit Regulations"
(page 5 of the 1992 ICAEW, ICAS and ICAI annual report on Audit
Regulation). The focus on mechanical compliance with auditing
standards (which are not independently formulated) pays little
attention to the organisational culture that facilitates conflict
of interests, possible falsification of audit work and the institutionalisation
of audit failures.
The public has a right to know the identity of producers
of goods/services who produce goods/services of unacceptable quality.
But the accountancy bodies do not act in the public interest.
When the ICAEW was asked for the names of the firms whose work
has failed to meet its standards, it replied:
"It is not our practice to provide lists of firms visited
other than to the Audit Registration Committee" (letters
dated 1 December 1992 and 5 February 1993).
The public bears the cost of regulation but is not given
information about the poor standards of auditing.
In principle, accountancy bodies could support calls for
changes to the legal and institutional structures so that the
auditing firms are persuaded to revise organisational structures
and values that construct an audit. However, their position is
compromised by the pursuit of narrow economic interests. Despite
acting as statutory regulators, they routinely side with the producers/sellers
of audits (Cousins et al., 1998; Mitchell et al., 1998)
and consider themselves to be primarily "responsible for
protecting and promoting the interests of (their) members"
(Certified Accountant, September 1991, p 12). In pursuit of such
policies, they have a history of opposing any association of audits
with detection and reporting of fraud (Sikka et al., 1998).
Even in the aftermath of the closure of the Bank of Credit and
Commerce International (BCCI), the auditing industry opposed the
imposition of any "duty" to report financial irregularities
in financial businesses (eg banks, insurance and financial services
companies) to the regulators (Bingham, 1992). The accountancy
bodies have often sided with corporate elites to oppose change.
For example, they have opposed obligations for companies to publish
the profit and loss account, balance sheet, market value of assets,
group accounts, movements on reserves, audit reports, corporate
turnover, payments to auditors for non-audit work and the need
for companies to have independent audit committees, just to mention
a few (Puxty et al., 1994). The position adopted by the
accountancy bodies sees the social problems from the perspective
of the auditing industry and its patrons, and rarely from the
perspective of the wider public that might be affected by their
policies. Overall, the regulatory activities do no focus upon
the organisational practices and values that give rise to audit
failures.
SUMMARY AND
DISCUSSION
Auditing functions as a technology that facilitates harms
to many stakeholders. Audit failures are highlighted by unexpected
corporate collapses and scandals rather than by accountancy firms
or their regulators. As long as a company survives, the audit
failures continue to be glossed over. In times of recessions and
economic downturn, the frauds and fiddles can no longer be covered
and audit failures come to light. Audit failures have played a
part in the loss of jobs, homes, savings, taxes, pensions and
investments. Audit failures are crafted by the culture and organisational
practices institutionalised within accountancy firms. However,
they are rarely subjected to any critical scrutiny by the state
or the regulators.
Audits are performed by "private" commercial organisations.
In common with other capitalist organisations, the requirement
to increase fees and profits shapes their organisational practices
and culture. The evidence cited in this paper shows that in pursuit
of profits, accountancy firms standardise audits and exploit labour,
expecting staff to work excessive hours for no/little pay. Some
staff respond to such pressures by resorting to irregular auditing
practices, unauthorised short-cuts and falsification of audit
work. Despite the proliferation of auditing standards on planning,
controlling, recording and review of audits (Auditing Practices
Committee, 1980), the audit working papers are not necessarily
reviewed by another partner/manager. Firms routinely destroy notes
and files that might assist investigators (Department of Trade
and Industry, 1995, p 324-325). Despite laws strengthening the
position of resigning auditors, accountancy firms seem to be keen
to walk away quietly. To advance their economic interests, audit
firms seem to enter into private deals with company directors,
assuring them that they will obstruct inquiries and not easily
provide meaningful information to stakeholders. Some accountancy
firms have also devised organisational structures that thwart
co-operation with the regulators. They are headquartered in offshore
financial centres that are known for their secrecy and lack of
co-operation with international investigators and regulators (Mitchell
et al., 2002). Such structures and practices are the result
of carefully nurtured organisational policies and values, put
in place after careful discussions amongst partners and with legal
advisers. The organisational practices seek to advance the short-term
economic interest of auditing firms and provide the context for
understanding audit failures.
In an environment that links performance to profits, bonuses,
salaries and promotion accountancy firms (and their partners)
are not keen to offend corporate sensitivities, as a reputation
for being troublesome may not be conducive to securing auditing
and lucrative consultancy business. Audit failures "reveal
shortcomings in both vigilance and diligence" and "a
failure to achieve an appropriate degree of objectivity and scepticism"
(Joint Disciplinary Scheme, 1999). Rather than focusing attention
upon the role of organisational cultures and practices in facilitating
audit failures, the tendency of the auditing industry and its
regulators is to deflect attention. The typical strategy has been
to individualise audit failures (Sikka, 2001), blame company directors,
corporate governance practices, lax accounting standards and the
expectations of significant others (Sikka et al., 1998).
This way, the organisational practices and values responsible
for audit failures remain shielded from scrutiny and audit failures
remain institutionalised.
Some questions about organisational practices could be raised
by the availability of meaningful information. However, accountancy
firms are some of the most secretive organisations in the world.
Little is known about their financial[41]
and organisational[42]
affairs. Information about auditor relationships with companies,
conflict of interests, details of the audit team, audit contract,
audit effort, profitability and contents of auditor files is remarkably
scarce. In principle, the imposition of stringent liability and
"due care" laws could persuade accountancy firms to
reflect upon the consequences of their organisational practices.
However, the legal environment is weak and the UK auditors do
not owe a "duty of care" to individual shareholder,
creditor or other stakeholder. Due to inequalities in wealth distribution
and cuts in legal-aid, many injured stakeholders do not have the
necessary financial, legal and political resources to challenge
the firms and facilitate a public scrutiny of their organisational
practices. The regulators could generate pressure for changes
in cultures dominating accountancy firms, but they have a close
and cosy relationship with auditing firms. The auditing industry
is regulated by the accountancy trade associations who are also
responsible for promoting and defending the industry. To be effective
regulators also need economic pressures, but they do not owe a
"duty of care" to anyone relying upon their monitoring,
licensing and disciplining activities.
Problems of auditing are the result of the business ideologies.
Yet no auditing regulator is examining the shift in capitalist
economies. The 1980s and the 1990s are characterised as marking
a major shift (in the Western world) from industrial capitalism
to finance capitalism where money itself has become a commodity.
Due to technological developments, money can easily roam the world.
There is no longer any relationship between money, credit and
the productive economy. Rather than directly investing in the
production of goods and services, corporations make money by placing
clever bets (gambling or hedging) on interest rate movements,
exchange rates, security prices, commodities and land speculation.
Under such circumstances, traditional ex-post audits are of limited
use. Not surprisingly, many of the major scandals and audit failures
have occurred in the financial sector (BCCI, Savings and Loan,
Levitt, Barlow Clowes, Wallace Smith, Barings, Yamaichi). Yet
this malaise is no longer restricted to just the financial sector.
Companies in all sectors are pursuing get-rich quick schemes,
Enron, primarily an energy company had been heavily engaged in
financial engineering. Major companies (Enron, BT, NTL, Vodaphone
NewsCorp) are funding their growth by debt rather than equity.
Enron was one of the world's largest traders in derivatives. The
value of corporate debt (unlike bank loans) is not fixed. This
debt-fuelled economy requires new reflections on accounting, auditing
and regulation. Are ex-post audits of any use? Should banks have
real-time audits? Such questions cannot be considered by accountancy
trade associations or the Accounting Standards Board (ASB) since
they are concerned with micro issues and do not always consider
the macro developments.
The socio-economic changes call for reflections on new economic
developments and alternative modes of audits. Faced with the changing
social context, auditors have sought refuge in traditional "duty
of confidentiality" to client. This prioritising of "private"
interest over the "public" interest has injured numerous
bank depositors, pension scheme members and other stakeholders.
Clearly new institutional and legal practices are called for.
These could include the performance of audits by the staff of
the regulators. Taxation authorities (eg Inland Revenue, Customs
and Excise) are already empowered to conduct independent audits
of specific aspects of business. Could their jurisdiction not
be extended? The employees of the regulators (eg the Financial
Services Agency) could conduct audits. Unlike the BCCI auditors,
they would not easily be able to hide behind the veil of "confidentiality"
and refuse to co-operate with regulators. Neither will they be
able to act as consultants to the audit clients and acquire a
vested business interest. Auditors frequently claim that the public
does not understand the functions and purposes of an audit. Therefore,
it can't have too many objections, if the representatives of the
public takeover the external audit function.
As the auditing industry has "ditched any pretence of
their being public spirited" (Hanlon, 1994, p 150), its interests
should be secondary to those concerned with the protection of
stakeholders. Subject to suitable safeguards, it does not matter
who conducts audit or forces corporations to be accountable. The
development of alternative policies can enrich public debates.
It could be argued that external audit be made non-mandatory and
replaced with new public policies. One could require all companies
and their directors to have compulsory insurance (say some multiple
of gross assets) so that adequate protection is available to stakeholders
against fraud The second policy would require the introduction
of legislation that specifies (or authorises a regulatory body
to specify) the kind of information which companies must publish.
Failure to publish the required information and maintain adequate
insurance cover would be a criminal offence and would make directors
personally liable for company's debts. As insurance premiums would
be dependent upon some estimation of risk, insurance companies
could ask accountancy firms to make appropriate investigations
and report. In such circumstances, the insurance companies and
the auditing firms would have to negotiate the terms on which
corporate risks are to be assessed. It is also likely that many
auditing firms would have to accept fraud detection/reporting
as an objective of each assignment, possibly in return for a negotiated
ceiling on liability. Under such scenarios, the audit function
(as we now understand it) would in practice be taken over by the
insurance industry, but the public would have considerable protection
from frauds. Do the governments have the desire to think new policies?
If the current policies are to be pursued then, ideally,
company directors should have no say in the appointment and remuneration
of auditors. Audits of major companies should be carried out by
a government department. Government should empower the National
Audit Office, Inland Revenue and Customs and Excise to perform
company audits. This might not only produce independent audits
but also increase the tax revenues, as auditors would be less
willing to go along with doubtful practices. Whose visit is likely
to worry company directors more? The visit from Inland Revenue
or a visit from the local accountancy firm? However, we do not
live in an ideal world. Governments are unlikely to have the backbone
to support such proposals. Accountancy firms and their patrons
would mobilise their economic and political resources to oppose
anything that tightly curbs their ability to mould financial statements.
Therefore, one is looking for the ninth best solutions. The
solutions have to be appropriate for dealing with a powerful industry
that routinely fails and harms innocent people. If audits are
to be conducted by the private sector then a large number of reforms
are needed. Some are mentioned below:
— Instead of 23 separate regulators, a single statute-based
independent regulator, namely a Companies Commission, should regulate
accountancy business. It should take over all the licensing and
monitoring powers currently exercised by the accountancy trade
associations.
— The members of the Commission must sever all connections
with their employers so that unlike their part-time counterparts
in the current ASB and APB, they can speak openly on all issues
without fear of sanctions by their paymasters. To minimise the
chances of "capture", members should serve for a maximum
of five years. Accounting and auditing issues are essentially
about wealth distribution, accountability, risk management, social
justice and fairness. Therefore, the membership should reflect
a wide constituency. Accountants, as technical experts, should
be available in an advisory capacity. Structures and processes
should not be dominated by the cloak of technical interests. The
assumed technical experts should not be able to formulate social
policies under the guise of "techniques" to mystify
others.
— The Commission should meet in the open and pursue
a "full sunshine" policy. Agenda papers and minutes
should be accessible to any member of the public on the payment
of modest fees. The composition and terms of reference of all
working parties should be announced and the results of votes publicly
available.
— Public hearings should be an integral part of
the accounting/auditing standard setting process. It should be
an offence for two or more members of the regulatory body to meet
in private and fix the contents of proposed regulations. Indeed,
at the beginning of each meeting, members should clearly state
that they have not violated this requirement.
— Unlike the present position, the regulator should
owe a "duty of care" to the parties affected by its
decisions.
— Complaints against the Commission should be investigated
by an independent Ombudsman with periodic scrutiny from the Parliamentary
Trade and Industry Select Committee.
— The Companies Commission should each year review
the changes in the economy and consider the resulting changes
needed in accounting and auditing.
— The Companies Commission should consider ways
of expanding supply of auditors. For example, by authorising new
organisations (eg Inland Revenue, National Audit Office) to conduct
company audits.
— The Companies Commission should have its staff
to investigate incidences of audit failures and publish speedy
reports.
— The Companies Commission should have a statutory
right of access to all auditor working papers. It shall have powers
to investigate the overall standards and organisational practices
of firms implicated in audit failures.
— The Companies Commission should have the right
to pass copies of auditor working papers to recognised international
regulators. Thus accountancy firms should not be able to obstruct
(as in the case of Enron, BCCI, Barings, International Signal
Corporation Group) international inquiries.
— The Commission shall have the powers to fine and
prosecute firms. It shall also secure undertakings from the firms
eg to improve their quality control and organisational practices.
— To ensure that the public is protected, the Commission
shall list the names of the firms whose standards have been found
to be inadequate during any monitoring visit.
— Auditors and stakeholders should be able to see
a judicial review of the recommendations of the Commission.
— Companies should have directly elected (eg by
shareholders and employees) non-executive full-time directors.
They should not be able to hold numerous directorships simultaneously.
The non-executive directors should seek suitable auditors and
make appropriate recommendation to stakeholders. Stakeholders
should be able to field alternative candidates for the office
of the auditor.
— Company auditors shall be elected by a simple
vote of individual shareholders, employees and bank depositors,
where appropriate. Directors shall not be able to subvert this
decision by casting proxy votes.
— Auditors should act exclusively as auditors. The
state guaranteed mark of external auditing was not given to accountants
to enable them to use it as a stall for selling other services.
Auditors should not be allowed to sell consultancy services to
any audit client. Neither the audit firm nor any of its associates
shall be a party of any part of the financial statements being
audited. In reality, Auditors have become personnel departments
and extensions of finance departments of the companies they audit.
In Germany auditors are prohibited from selling consultancy services
to audit clients. In the UK, the Audit Commission appoints local
authority auditors. They are generally prohibited from selling
consultancy services to the local authorities that they audit.
In the corporate sector, auditing firms devise tax avoidance schemes,
off-balance sheet financing schemes, dream up creative accounting
ideas, corporate strategy, write-up books, advise on mergers,
acquisitions and factory closures. All this makes them as dependent
as any other door to door salesman. It compromises their independence.
The auditors are expected to act as referees and umpires, but
their reliance on directors and their financial involvement with
the companies give them little incentive to report unsavoury practices.
They cannot be independent of the directors and have acquiesced
to numerous novel accounting practices. As the accountancy trade
associations frequently claim, "the auditors not only needs
to be, but must also be seen to be independent".
— At every AGM there should be a declaration that
the directors have not used auditors or any of their associates
for any non-auditing services.
— No auditor shall remain in office for a period
exceeding five/seven years. In France, auditors are changed every
seven years and it works fairly well. The longevity of the auditor's
term in office played a part in auditor silence at Maxwell, Levitt,
Polly Peck, Grays Building Society and many other places. A fresh
broom and eyes are highly desirable.
— Where the company's auditors have been changed
during the year then a report shall be filed with the Registrar
of Companies stating the matters discussed by the directors with
the proposed auditors. If any of the company's accounting policy
changes coincide with the replacement of auditors then they shall
be explained and the auditors should state whether they have agreed
to such changes. "Opinion shopping" is a widespread
phenomena in the UK. Directors approach auditing firms and ask
whether they approve of particular accounting policies, frequently
designed to show company performance in the best possible light.
Directors have economic incentives to go "opinion shopping,
as their salary, pensions, perks and bonuses are increasingly
linked with accounting measures rather than market shares, innovations,
quality of production as happens in Japan and Germany. The legal
fiction is that auditors are hired and fired by shareholders.
The practical reality is that auditors are hired and fired by
directors and they can be in close collusion even to the extent
to devising tax, transfer pricing and other accounting dodges.
For all practical purposes, directors are the "clients"
of auditors. Auditors depend upon directors for their continuation
in office and in the face of competition from other firms, they
are all too willing to push accounting interpretations to the
limit. Public disclosure is a vital means of alerting the public.
— Auditors duties should be clarified by statute.
The Companies Acts spell out the directors' duties in considerable
detail. Similar detail is absent for auditor responsibilities.
The auditing industry is quite happy for it prefers vague arrangements
which enable it to shield its fee earning opportunities. The professional
bodies claim that auditors are not responsible for detecting and
reporting fraud (after BCCI the financial sector auditors have
a "duty" to report irregularities to the regulators)
or for commenting on business efficiency, effectiveness and financial
soundness etc. Yet such audit objectives are common place in the
public sector. Auditors of all PLCs should be required to report
any material fraud or irregularity which they come across during
their normal audit, to the appropriate regulators.
— Auditor working papers should be available for
inspection by designated representatives of stakeholders (eg a
directly elected audit committee).
— No member of the audit team can obtain paid employment
with an audit client for a period of five years since the last
audit visit.
— Auditors shall owe a "duty of care"
to the individuals who are shareholders, creditors, pensions scheme
members and employees at the date of the audit report This means
that auditors are not liable to an indeterminate number of people.
— The incoming auditor should have statutory right
of access to the files and working papers of the outgoing auditors.
This will enable them to make a better and informed assessment
of the desirability of the client and also appreciate the validity,
or otherwise, of the statements issued by the resigning auditor.
— Anyone authorised to conduct the audit of a public
limited company should be required to publish meaningful information
their affairs. They should be required to file copies of the audit
contract, audit tender, report on companies internal controls,
composition of the audit team, relationship with company directors,
assurance given/received from directors, conflicts of interests,
details of meetings held with the audit committee, and so on.
If we are to transform the existing practices, then a first
step must be to create a framework which allows various voices,
so far stifled, to be heard. The opening up of structures can
advance competing discourses and values, something that is essential
if real and emancipatory change is to take place. A strengthened
regulatory, legal and accountability environment would give auditors
incentives to reflect upon their narrow pursuit of economic interests.
Perhaps the above suggestions are too provocative. They are
sure to be opposed by the auditing industry which has a long history
of opposing change (Puxty et al., 1994, Bingham, 1992).
Yet can the auditing industry be constantly permitted to hold
the public to ransom and to dissociate itself from the consequences
of its own failures.
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26
"Risk" is a fairly loose term. In everyday language
"risks" tend to be associated with hazards, dangers,
threats or harms. Back
27
In the early 1990s, Enron outsourced its internal audit function
to Arthur Andersen. Back
28
The US Department of Justice (press release, 14 March 2002 has
formally charged Arthur Andersen with criminal conduct). Back
29
The term "culture" is subject to considerable debate.
Things in themselves rarely have any meaning. It is the participants
who give meaning to practices and situations. In the context of
this paper, "culture" is understood as the production
and exchange of meanings within an accountancy firm. It is constantly
produced and exchanged in personal and social interaction. Meanings
also regulate and organise the conduct of daily life (Hall, 1997). Back
30
The accounting numbers forming the basis of mathematic models
are themselves the product of the politics of the time. Back
31
Ironically, they are also threatening the survival of Enron's
auditors, Arthur Andersen. Back
32
The omissions and oversights were enough to persuade one commentator
to conclude that "what in a working-class occupation would
be seen as blatantly corrupt, in a middle-class one is seen as
a badge of pride" (Jenkins, 1999). Back
33
According to government ministers, "unless the auditor uses
a statement for some improper purpose-for instance, he is malicious
in the legal sense-no person who is criticised will be able to
sue him successfully for libel" (Hansard, House of Lords
Debates, 5 April 1976, col 1488). Back
34
Curiously, Peter Aigner was simultaneously appointed a DTI inspector
to investigate auditor failures whilst the conduct of his own
audits was under investigation. The DTI did not publish the final
report. Back
35
Such claims are easy to make, as auditing firms are some of the
most secretive organisations. Nevertheless, on occasions authoritative
investigators have associated audit failures with the sale of
consultancy services to audit clients (US Senate, 1992; Department
of Trade and Industry, 1976, 1979). Back
36
The Banking Act of 1987 required regular meetings between bank
management, auditors and the Bank of England to discuss matters
of mutual interest. The auditors' traditional duty of confidentiality
to client companies was relaxed to allow them to report matters
to regulators provided they acted in "good faith". Back
37
It may be argued that auditors did no wish to qualify the accounts
of a bank, for the fear to causing a run. However, in 1999 PricewaterhouseCoopers
issued a qualified report on the 1997-98 accounts of the Meghraj
Bank, a major Asian bank with branches in the UK (Financial
Times, 19 May 1999, p 23). Back
38
Price Waterhouse (UK) partners did agree to be interviewed by
Subcommittee staff in PW's London office. The offer was declined
due to concerns that the interviews would be of little use in
the absence of subpoenaed documents (US Senate, 1992, p 258). Back
39
http://www.accountingweb.co.uk (accessed on 10 April 2002). Back
40
Most of the major lawsuits are usually by one accountancy firm
(in its capacity as a receiver or liquidator) against another
(Cousins et al., 1998). Back
41
Despite campaigning to secure the right to trade as limited liability
companies, most audit firms shunned this possibility because "firms
have always stood out against revealing any financial information
except their annual fee income" (Accountancy, April 1994,
p 26) and that "the obligation on (auditing firms trading
as) companies to publish their accounts is perceived as a considerable
drawback" (The Accountant, September 1991, p 2). Back
42
Little is known about the organisational structure of major accountancy
firms. The US Senate's hearings on the closure of the Bank of
Credit and Commerce International (BCCI) showed that Price Waterhouse(UK)
is owned by Price Waterhouse Worldwide, based in Bermuda (United
States, Senate Committee on Foreign Relations, 1992). Back
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