Concentration of Power Undermines Progress

Profit-maximizing companies take advantage of loopholes at the expense of consumers and the exchequer. This is why auditors and regulations have been put in place to protect the public from corporate abuses — By Anil Gujadhur

This may look like an awkward comparison but it may be worth the while explaining how the strong and powerful end up dominating the rest. Just as there are three to four superpowers dominating the world, not necessarily for the good of the countries they dominate, there are four big accounting firms dominating the global auditing business. Together, they account for the auditing of 99% of the world’s biggest companies listed in corporate indices such as S&P 500 and FTSE 100.

The latter are usually referred to as the ‘Big Four’: Deloitte, KPMG, PwC and Ernst & Young. There were five earlier on, but one of them, Arthur Anderson, went under when two US giants, WorldCom and Enron collapsed, with investors losing $200 billion as the book-cooking taking place for years in these companies, undetected by the auditors, came to light.

Concentration of auditing has not always been for the best to ensure the good health of the corporate sector. Since the ‘Big Four’ have an extensive coverage of the global corporate sector, they gather exclusive experience about company matters. It is the reason why they offer not only accounting and auditing services; they are also extensive providers of counselling and tax advice opinions to firms.

Any other service provider would have taken advantage of its proximity with top global clients to win ever more and more contracts of service, be it for auditing, counselling or tax advisory services. Moreover, because the competition is more or less limited to one among them, big audit firms have been seen to be providing services to the same companies over long stretches of time. The cosiness which thus develops between owners and managers of firms, on the one hand, and the perpetuating audit firm, on the other, can give rise to numerous complacencies and, indeed, situations of conflict of interest. According to The Economist (16 Dec 2017), “all of the ‘Big Four’ have been caught up in scandals in recent years, particularly in emerging markets”.

An Example

On January 11th this year, the Securities and Exchange Board of India (SEBI), which regulates listed companies, has banned the audit firm, Price Waterhouse (PwC) from auditing of Indian listed companies for two years starting from 31st March 2018. The sanction relates to the audit of the once well-known flourishing Indian IT firm, Satyam Computer Services (Satyam).PwC is appealing SEBI’s decision, stating that it hasn’t been involved in “intentional wrongdoing”.

It need be recalled that Satyam collapsed in 2009 after the discovery of irregularities involving the company’s chairman and three others (jailed for 7 years subsequently) in a fraud of $1.7 billion. Share prices collapsed overnight, leading to losses amounting to $2 billion to investors. It seems that, over the last five years to 2008, the company had been cooking up its books by means of an extensive fraud. The fraud consisted of inflating the prices of the company’s assets, employing fake invoices to understate the company’s real debt and losses and artificially inflating its revenue and cash position. Sounds familiar, doesn’t it?

SEBI’s decision against the firm’s auditor, PwC, is coming several years after the discovery of the long-standing fraud. Nevertheless, it is a signal being sent not only to those within the firm who abuse but also to those entrusted with a duty to keep a watch over incorrect financial reporting (the auditors) who aid and abet abuses, howsoever strong their global affiliation. SEBI has stated that “persons tasked to protect the interest of investors were hand-in-glove with the main perpetrators of the fraud”.

This is because PwC audit did not independently check the company’s real cash balances from monthly bank statements they received but remained content to endorse, over several years, the cooked-up inflated false balances presented by management and its in-house accomplices. After all, given its market standing as part of the ‘Big Four’, PwC Audit’s clean opinion year-in year-out on the company’s accounts acted as a stamp of approval of the highest order. Some companies, especially the big ones, have tended to treat audit as a routine annual exercise, always ending up in a clean opinion. They can’t do wrong, it seems.

Issues of Good Governance

Audit firms are regarded as one of the guardians of free capitalism. To do justice to this enormous responsibility, they have to be fiercely independent. Profit-maximizing companies take advantage of loopholes at the expense of consumers and the exchequer. This is why auditors and regulations have been put in place to protect the public from corporate abuses in their drive to paint as rosy a picture of themselves as possible in order to drive up share prices and obtain undue advantages to the detriment of the public.

Without effective checks and balances, it may be too late by the time the abuses are detected and stopped. Auditor independence is key to ensuring that companies don’t overstate their profits or hide away or understate their real losses. Timely action is required to stop the abuse before the harm becomes too disproportionately large to manage. Unless so, one might end up explaining Satyam’s failure to arrest the abuse before it was too late by its complicit chairman’s statement that it was “like riding a tiger, not knowing when to get off without being eaten”.

There are plenty of examples the world over, no less in next door Africa, where armies and political leaders have focussed so much on their mutual interests, especially economic and social interests, that it is difficult to disentangle the proper role of one from the other. Kim Jong Un of North Korea is nearly always surrounded by army generals. President Donald Trump has stated he is no far from his “nuclear button”.

The Revolutionary Guards of Iran are closer to the Supreme Leader than to the masses protesting against economic hardships they face. Nearer to us, close ties between the army and just-ousted president of Zimbabwe have helped undermine the economy over decades. The Democratic Republic of Congo has set another example, if at all it was necessary, of how the army, which is supposed to protect the population, has instead killed six of them in a repressive bid to perpetuate the President Joseph Kabila’s stay in power beyond Constitutional provisions.

Coming back to the audit issue, it is to avoid the confusion of respective roles that regulators are asking auditors to henceforth not only satisfy the low bar of expressing an opinion as to whether the accounts have been properly drawn up. They are being asked to publicly bring out what are called “critical audit matters”, that is, issues on which they had disagreements with company management in the course of the audit. If that salutary distance is created, those who trust companies will be better protected.

 

 

* Published in print edition on 26 January 2018

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