Big Four Audit “Oligarchy” Comes under Scrutiny in the UK after Corporate Surprise Collapses

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The “oligarchy” controls the standard-setters, ensuring rules of the game suit it. The long reach of the bean counters also extends deep into the heart of government.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

KPMG, one of the world’s “Big Four” accounting firms, has shown an “unacceptable deterioration” in auditing British firms and will be subject to closer supervision, the UK’s top accounting watchdog warned on Monday. “Fifty percent of KPMG’s FTSE 350 audits required more than just limited improvements, compared to 35% in the previous year,” the Financial Reporting Council (FRC) said.

In other words, KPMG’s UK auditing division got about half its work in the last year badly wrong and is about to have its auditing work more closely audited. The increased scrutiny of KPMG will involve the FRC inspecting 25% more audits done by the firm in the 2018-19 financial year, the first time the FRC has taken such action.

KPMG is under the spotlight in large part due to its abject failure to properly audit the UK outsourcing giant Carillion, which collapsed at the beginning of this year. Between 2012 and 2016, Carillion ran up debts and sold assets just to continue paying out dividends to shareholders. Yet in Carillion’s last ever annual report, KPMG approved Carillion’s viability statement, certifying it as strong enough to survive for “at least three more years.” Within less than three months, Carillion was bankrupt.

The biggest asset on Carillion’s books was £1.57 billion of “goodwill” — an intangible asset that arises when one company purchases another for a premium value. It does not include physical assets like buildings or equipment, of which Carillion, as an outsourcer, had almost none. Instead it is supposed to encapsulate the additional value provided by intangibles like a company’s brand name, solid customer base, good customer relations, and any patents, or proprietary technology.

Thanks to the unending M&A boom and recent accounting changes, this “hope” value has become a significant part of corporate balance sheets. During recent grilling by two select committees Stephen Haddrill, chief executive of the Financial Reporting Council (FRC), said that while it was “not good practice” to have so much goodwill on the balance sheet, it was “not untypical.”

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Since 2005, companies have been able to treat goodwill as a permanent asset, only writing it down if it is deemed “impaired” by the company and its auditors. But impairment tests are decidedly subjective and their outcome largely depends on the honesty of a firm’s management and its auditors, a somewhat dicey proposition.

On KPMG’s watch, Carillion was able to attribute £329 million of goodwill every year for seven years to a public contractor it acquired in 2011, despite the fact the company had become “virtually worthless” not long after its acquisition. By 2016, the subsidiary’s revenues had shrunk to just £43 million (that’s down 95% from its pre-takeover level), and it had run up cumulative losses of an astonishing £350 million under Carillion’s ownership. Yet it was still generating £329 million worth of assets on Carillion’s annual balance sheet.

KPMG seemingly had no issue with that, which raises further questions about its capacity to audit British companies. The Dutch-based auditor has already had a leading role in some of Britain’s biggest corporate disasters of recent years, including the highly controversial collapse of the high street lender HBOS, which was subsequently covered up by the FRC .

But it’s not just KPMG that’s under the spotlight. Following a string of high-profile corporate scandals the FRC has launched an inquiry to explore the possibility of breaking the audit arms of all Big Four accounting firms — KPMG, Deloitte, Ernst & Young, and Price WaterhouseCoopers — into separate pieces. Frank Field, who chairs the Work and Pensions Committee, said there was an “oligarchy” in the sector and asked whether the committee should recommend that the four firms be broken up.

An article in The Guardian aptly titled “The Financial Scandal No One Is Talking About” points out that alumni of the Big Four control the international and national standard-setters of the accounting industry, ensuring that the rules of the game suit the major accountancy firms and their clients. The long reach of the bean counters also extends deep into the heart of government:

In Britain, the big four’s consultants counsel ministers and officials on everything from healthcare to nuclear power. Although their advice is always labelled “independent,” it invariably suits a raft of corporate clients with direct interests in it. And, unsurprisingly, most of the consultants’ prescriptions – such as marketisation of public services – entail yet more demand for their services in the years ahead.

In the UK, the Big Four audit 99 of the FTSE 100 companies and 97% of the FTSE 350, up from 95% five years ago, despite EU and UK reforms ostensibly aimed at tackling a lack of competition in the sector. It’s a pattern that is replicated throughout advanced economies. In the vast majority of EU Member States the combined market share of the big four audit firms for listed companies exceeds 90%. But it’s in the consulting business where the real money is being made.

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And real money is definitely being made. In 2017, the big four’s combined global annual revenues reached $134 billion. And the rate of their growth keeps expanding faster than the world they serve, as The Guardian reports:

In their oldest markets, the UK and US, the firms are growing at more than twice the rate of those countries’ economies. By 2016, across 150 countries, the big four employed 890,000 people, which was more than the five most valuable companies in the world combined.

Given the amount of wealth, power, influence, and control the big four have accumulated in recent decades, trying to bring them back down to a more manageable size is going to require a herculean effort. But at least it’s an idea that’s finally getting some attention. By Don Quijones.

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