MG Rover debacle can’t hide accounting regulation failures

Prem Sikka

The UK accountancy watchdog has barked. The Financial Reporting Council (FRC) has fined Deloitte & Touche £14 million for failures relating to the demise of MG Rover. The report says Deloitte was engaged in huge conflicts of interest as the firm acted both as auditor and advisor to the company and its directors.

The MG Rover debacle began in 2000 when four businessmen (subsequently known as the Phoenix Four) bought the ailing carmaker from BMW for just £10. The purchase was accompanied by a loan of £423 million from BMW and the UK government also provided additional funds. Deloitte acted as auditor of MG Rover and an adviser to the Phoenix Four. The company continued to receive a clean bill of health from auditors. Between 2000 and 2005, the Phoenix Four collected around £42 million in remuneration. With advice from Deloitte some £7.7 million ended up in an offshore trust in Guernsey. In 2005, the company collapsed with debts of nearly £1.4 billion. Some 6,000 workers lost their jobs.

Following a public outcry, the Department of Business Innovation and Skills appointed inspectors, one of whom was an accountant, to investigate the debacle. The two volume report (here and here ) cost £16 million and was published in 2009. The report noted that between 2000 and 2005, Deloitte received £30.7m in fees, of which £28.8m related to consultancy, that is, only £1.9 related to audits.

Deloitte was advising the company and its directors and then audited the resulting transactions. Hence the concerns about possible conflicts of interest and the disciplinary tribunal’s conclusion that Deloitte “failed to be sufficiently objective in its work for MG Rover”. Deloitte is found guilty of “misconduct” and the FRC report states: “the acts which amount to misconduct were quite deliberate” and the firm and its lead partner “placed their own interest ahead of that of the public and compromised their own objectivity. This was a flagrant disregard of the professional standards.”

The FRC’s reputation as an accounting watchdog was severely battered by the banking crash. All distressed banks received a clean bill of health from their auditors even though depositors were queuing outside banks to withdraw their cash and governments were bailing out banks. The FRC failed to investigate any of the auditing firms. The MG Rover debacle has given it an opportunity to reinvent itself. The £14 million fine on Deloitte is the highest ever against any accounting firms. But all is not what it seems.

For any regulatory system to be effective regulators need to act swiftly. That has not been the case for the FRC. It initially announced its intention to investigate the conduct of Deloitte as auditor and adviser to the MG Rover Group in August 2005. The wheels of the profession grind slowly and then it claimed that will proceed after the inspectors’ reports if finalised, which was published in 2009. It has taken the FRC another four years to do anything. This is hardly a model of swift action.

The £14m fine may be the largest ever, but needs to be seen in perspective. It is less than half of the £30.7m fees collected by Deloitte. So despite failures and “misconduct”, the firm has still made considerable profit. The firm’s UK revenues are around £2.5 billion; that’s £6.85m a day. The fine amounts of the loss of about two days' revenue. This is unlikely to make accountancy firm partners quake in their boots.

The fine will fill the coffers of the FRC and will not be used to compensate creditors, employees, or taxpayers who provided social security and other benefits for the redundant workers.

The MG Rover episode does not herald a new dawn in the regulation of auditors. Despite the toxic effects of conflicts of interest and calls from parliamentary committees, the FRC has resisted a total ban on auditors acting as consultants for companies. So companies will continue to audit the transactions they themselves have overseen. Some of the darker practices could be flushed out and given public visibility by compulsory tendering of audits, but the FRC opposes that too.

For the time being, the MG Rover episode may legitimise the FRC’s regulatory credentials but the fault lines are as big as ever and will not go away.

• This article first appeared on The Conversation website

The race is on, but the field is limited in the auditing business

Prem Sikka

Isn’t it interesting how governments go through the rituals of promoting competition, but little actually changes? The latest example is the UK Competition Commission’s report on the UK auditing industry.
The report is supposedly concerned with enhancing competition in the UK auditing market. The current position is dire. Thanks to the close alignment between corporate interests, policymakers and politicians, successive governments permitted restrained mergers.

Today the auditing market is dominated by just four accounting firms. These are PricewaterhouseCoopers, Ernst & Young, Deloitte & Touche and KPMG (known as the Big Four firms), and between them they audit 99 of the UK’s biggest listed companies (FTSE100) and around 240 of the next 250. On average, a FTSE100 auditor remains in office for about 48 years; for the FTSE250 the average is 36 years. The Big Four firms are dominant in most western countries. Their global income from auditing and consultancy services is about £77 billion (US$115 billion) and some £7.9 billion ($11.9bn) of it comes from the UK. This provides plenty of financial and political resources to thwart any unwelcome policies.

The probability of another accounting firm breaking into this magic circle is extremely low as the entry costs are high. The challengers need help but there is little on the table from the Competition Commission. The Commission does not want to break-up the Big Four firms or place any limits on the proportion of market they can dominate. It does not want to place any time limits on the audit firm’s tenure either.

This monopoly of company audits has been the springboard for the growth of the Big Four accounting firms. Audits give accounting firms easy access to company boards and lets the accountants sell all kind of additional services, ranging from tax avoidance, advice on mergers and takeovers to printing T-shirts, badges and laying golf courses. All this increases fee dependency on clients and must lessen the probability of speaking out against unsavoury practices. At the dawn of the banking crash, concerned savers were forming queues outside distressed banks and governments were bailing out banks, but auditors gave their customary clean bill of health to all distressed banks. This silence was not followed by any investigation by the UK government. There is no action by any regulator either. Even if they act, it takes years. The matters relating to the audit of automaker MG Rover by Deloitte were referred to the Financial Reporting Council, the UK regulator, in 2005. It finally reported on 29 July 2013.

The regulatory inertia neither encourages competition nor improves the quality of audits. Last year, a tax tribunal heard a case relating to a tax avoidance scheme designed by Ernst & Young for Iliffe News and Media. The company was very profitable, but was concerned that healthy profits would encourage employees to demand higher wages. So Ernst & Young, who were also the company’s auditors, designed a scheme that would artificially depress profits and avoid tax too. The company’s board minutes stated that Ernst & Young confirmed that the use of the scheme would also “significantly lessen the transparency of reported results”. Despite such episodes, the Competition Commission does not want to ban the sale of consultancy by auditors to their audit clients. The best that it can come-up with is that companies might put audits out of tender every five years.

The Competition Commission could have increased the market pressures on auditors to improve quality of audits by empowering consumers of audit opinions, but it does not do that. Auditors only owe a “duty of care” to the company rather than to any individual shareholder, creditor or any other stakeholder. So individuals can do little to bring negligent auditors to book. Court cases such as MAN Nutzfahrzeuge AG & Anor v Freightliner Ltd & Anor [2007] show that there is little recourse against auditors even when they are found to be negligent.

At annual general meetings (AGMs) shareholders are asked to vote on auditor appointment and remuneration, but this resolution is not supported by any information about quality of audit work, lawsuits or regulatory action against auditors. Shareholders are not given any sight of auditor working papers. Shareholders have no idea of the work done by auditors. Auditing firms are commercial concerns and their success is measured by profits. In pursuit of profits, the firms reduce the time allocated to each audit even though audits are labour intensive and need a higher time budget. The hope is that aspiring accountants will work evenings and week-ends for free. Academic research shows that a large number of audit staff do not go along with such strategies and resort to falsification of audit work or ignore awkward transactions because they require more time than is allocated. Audit failures are manufactured by the business model and organisation culture of accountancy firms, but this does not even appear on the radar of the Competition Commission.

There is little meaningful public information about auditors. There is no public availability of audit contract, information composition of the audit team, time spent on the job, details of meetings with company directors, or anything else that might enable the consumers of audit opinions to assess audit quality.

The Competition Commission has capitulated to the lobbying power of the Big Four and failed to introduce any meaningful reforms. Maybe such issues will be considered after the next banking crash.


This article first appeared on The Conversation website

Auditors must be held to account

The shareholder spring is the perfect time to challenge the poor performance of unscrutinised accountancy firms

Shareholder spring is in the air, with increasing numbers voting against fat-cat executive rewards for failure and mediocre performance. However, the same scrutiny is not being applied to the business advisers and consultants implicated in headline failures. They continue to receive huge financial rewards. Company auditors are good example.

PricewaterhouseCoopers (PwC), Deloitte, KPMG and Ernst & Young, collectively known as the Big Four accountancy firms, audit around 99% of FTSE 100 companies. These firms audited all distressed banks. At the height of the banking crisis they gave the customary clean bill of health to Northern Rock, Abbey National, Alliance and Leicester, Bradford & Bingley, HBOS, Lloyds TSB and Royal Bank of Scotland (RBS). Bear Stearns and Lehman Brothers went bust shortly after receiving the all-clear. A subsequent inquiry by the House of Lords economic affairs committee accused auditors of "dereliction of duty" (para 161) and "complacency" (para 167) and basking in a culture of "box ticking" (para 6) rather than delivering meaningful audits. Despite the damning criticisms, some partners in audit firms still charge over £700 an hour for their services.

In 2011, Barclays, the bank that forced the government to introduce retrospective legislation to combat its tax avoidance schemes, paid £54m to its auditors PricewaterhouseCoopers, including £15m for consultancy and advice on tax matters. PricewaterhouseCoopers, which once audited Northern Rock, collected another £48m from Lloyds Banking Group , including £10m for consultancy. HSBC has paid a whopping £56m, including about £8m for tax and consultancy services to its auditors KPMG, the firm that audited HBOS and Bradford & Bingley. RBS has paid £41m, including £7.4m for consultancy to Deloitte, the firm that audited Abbey National, Alliance & Leicester and Bear Stearns. Ernst & Young, the firm that audited Lehman Brothers, earned £36m in audit and consultancy fees from BP and another £28.5m from Aviva. At major companies, the fees paid to accountancy firms are larger than CEO salaries, but rarely attract sustained media attention.

The auditor dependency on companies for vast fees neuters any impulse to deliver an independent opinion on company accounts. No one at any accountancy firm is ever promoted for blowing the whistle on dubious practices of companies and losing a client.

At company AGMs auditors are appointed often without any discussion. The resolutions on auditor appointment are not accompanied by any information on the composition of the audit teams; time spent on the job, audit and consultancy contracts, information obtained from directors, list of faults found with company accounts, regulatory action against auditors or anything else that might shed light on the quality of audit work or conflict of interests. With weak accountability measures, auditors deliver little of any social value.

The charges of "dereliction of duty" and "complacency" have not led to any worthwhile UK reforms though there is plenty of spin about encouraging auditors to be sceptical and tweaking auditing standards. There is no scrutiny of the basic auditing model which requires entrepreneurial accountancy firms to somehow invigilate giant corporations. The success of auditors is measured by private profits and they have no obligations to the state, or the public, which eventually bears the cost of bailouts and fraud. This mutual back-scratching has been a key factor in the debacles at Enron, WorldCom, Lehman Brothers and the banking crash. Yet no real change is in sight.

The EU is proposing minimalist reforms to check the collusive relationship between auditors and companies. These include a ban on the sale of lucrative consultancy services to audit clients and forcing companies to regularly change their auditors. At present, FTSE 100 companies change auditors every 48 years on average. Inevitably, major firms are using their financial and political resources to oppose even these modest proposals.

Major accountancy firms have got used to collecting mega fees for failure and mediocre performance. Shareholders should check that by turning the spotlight on them and demand refunds for poor performance. The government should sharpen liability laws so that auditors are forced to make good the damage done by their silence.

This article first appeared on Guardian Comment is Free