Big four accountancy firms called to account

The big four accounting firms are soon to face closer scrutiny.

The big four accounting firms — Deloitte, PricewaterhouseCoopers, Ernst & Young and KPMG — were said last year to have endured their ‘annus horribilis’ in Britain.

With so many fingers in so many pies, it was only a matter of time before somebody started asking questions.

The big four accounting firms — Deloitte, PricewaterhouseCoopers, Ernst & Young and KPMG — were said last year to have endured their “annus horribilis” in Britain.

That year started with a series of corporate failures, led by government contractor Carillion owing debts of £1.5 billion, which sparked a series of inquiries that resulted in questions about the quality and conflicts of interest of the big four’s auditing work. The year ended with Britain’s competition regulator recommending breaking up the firms’ audit business from their consulting arms, a new watchdog and tougher competition rules, putting billions of dollars at risk for the big four firms.

However, in Australia last year was a boon for the same four firms. Thanks to the banking and financial services royal commission, not only were the British problems overshadowed by the blowtorch being applied to major Australian banks, superannuation funds and insurers, the big four accounting firms also gained a mountain of work implementing remediation programs for ripped-off customers and won big contracts to overhaul long-neglected IT infrastructure at the major financial institutions.

The banking regulator even asked dozens of major companies to investigate their governance, triggering lucrative work that was picked up in the main by the advisory arms of the big four professional service firms.

But summer never lasts forever, and the coming year is looking to be very different for the big four. Since the federal election in May, three parliamentary inquiries have been established to investigate government contracting, potential conflicts of interest, quality of audits and regulation of the big four, foreshadowing potentially tougher penalties for misconduct, harsher competition rules on the cosy oligopoly or even the chance the government will forcibly separate divisions in the local arms of the multinational firms.

Gatekeepers of capitalism

Deloitte, KPMG, PwC and EY have come a long way from the Italian bookkeeping traditions invented in the 15th century.

From modest beginnings in 19th-century England, the big four have grown into sprawling global giants, employing more than a million employees in nearly every nation on earth and raking in $150bn in revenue each year.

They don’t seem to be slowing down either, and global revenue is growing at a stunning 10 per cent a year — almost twice as fast as the Chinese economy. With a firm grip on their core business of accounting auditing and tax advice, the firms have spiralled out into nearly every area of professional services. They have made their expertise vital in the world of management consulting, expanded their legal advice businesses and ploughed into the multi-billion-dollar technology and IT contracting industry.

The big four are now the gatekeepers of global capitalism, responsible for ensuring the accuracy and reliability of the fin­ancial accounts of nearly every major company in the world. The big four audit nearly 100 per cent of major companies listed on London’s FTSE index. Of the 500 largest companies on Wall Street, 497 are audited by one of the big four.

In Australia, companies representing 95 per cent of the $1.6 trillion market capitalisation of the local stock exchange are audited by one of the big four. Just about every major company, super fund and not-for-profit has some reliance on the services of the big four.

Government work grows

And since the business world is firmly wedded to their services, the big four have turned their attention towards government contracting, predictably so in a world of increased outsourcing and effici­ency dividends.

It has been a slow pivot that almost entirely has transformed what the big four do.

While global revenue for auditing work across the big four has held steady at about $45bn over the past five years, consulting and advisory revenue has risen from $38bn to $56bn — overtaking the primacy of audit.

And while much of this consulting work is management ser­vices and tax advice for business, governments increasingly are paying the big four for help.

In Australia, government contracting has grown to become a $47bn sector, on average, across the five years to 2017. That is an $8bn-a-year increase to the average $39bn for the previous five years to 2012.

Since 2015, the big four firms have won about $500 million — or 10 per cent — of this contracting work every year. That figure is double the average between 2011 and 2014, and is four times the average between 2008 and 2009.

Such is the wealth of tax expertise at the big four firms that the Australian Taxation Office has spent more than $40m during the past five years procuring their services. That is despite concerns about the big four’s involvement in several international tax avoidance scandals.

“In many profound ways, the so-called big four accounting and audit firms have influenced how we work, how we manage, how we invest and how we are governed,” author Stuart Kells and University of Melbourne professor Ian Gow write in their 2018 book, The Big Four. “The firms have been called many things. High priests of capitalism. More powerful than sovereign states. Protectors of the public interest … toothless lapdogs. A necessary evil. An institutional oligopoly … Skilled enablers of white-collar fraud.”

Closed shops

But while the services of the big four seemingly have become intrinsic to business and government, there is still much we don’t know about them.

Because they are not publicly listed companies, a great deal of what we know about their local fin­ancial performance comes from an annual overall revenue. For Del­oitte, that figure was $2bn last year. For KPMG, it was $1.6bn, and $1.7bn for both PwC and EY.

According to the ATO, getting a more thorough look at what happens inside is difficult as the big four firms are not single entities but a complex web of clusters of related parties usually structured as a main partnership that provides services to other related entities and a mixture of companies, partnerships and trusts.

But now a slew of parliamentary inquiries means there will be more transparency applied to these trade secrets. The first inquiry, triggered by the appointment of former defence minister Christopher Pyne to EY as a defence consultant, is investigating adherence of parliamentarians to the Statement of Ministerial Standards, which bars former ministers for 18 months from lobbying, advocating or having business meetings with government on matters they dealt with as a minister.

Last year, EY told parliament it had six partners who were former commonwealth SES officers or ex-senior military officers.

The firm has won 838 government tenders worth $377m across the past four years — $148m of that with Defence.

While EY is the focus, all four firms have expanded their Canberra bureaus during the past decade. PwC’s headcount in Canberra has ballooned from 232 to 341 staff members during the past five years, while KPMG’s headcount in the capital is about 500. Federal politics is increasingly important to the big four. During the six years through to last year, the big four have donated more than $4m to the major political parties.

Parliamentary probes

Because of the growing reliance on consultants and contractors, an inquiry into the outsourcing of government services was referred by Labor’s Bill Shorten to the Legal and Constitutional Affairs References Committee. Shorten said the inquiry would be “focused on exposing the flaws of outsourcing and privatisation” within the Australian Public Service.

It follows an escalation of the scrutiny on government outsourcing. The Commonwealth Auditor-General in 2017 conducted an unprecedented investigation into government procurement, which revealed that such high amounts were spent on external contractors it sparked a joint committee review into the system. It had a sharp focus on the big four accounting firms, although failed to produce a report before parliament was prorogued before the May 18 election.

Despite the growing amount of taxpayer funding secured by the firms, the Finance Department has declined to investigate total value of commonwealth contracts entered into with KPMG, EY, Del­oitte or PwC following the report.

Concerns about a potential blowout in taxpayer costs were downplayed by Finance Minister Mathias Cormann, who said the government had a “strong focus” on managing the cost of public administration as demand for ser­vices continued to grow. He said departmental expenses as a share of all government spending was down from 8.5 per cent in 2008 to 7 per cent last year. It was expected to fall to 5.4 per cent by 2023.

“The appropriate use of contractors and consultants is an appropriate way to keep the overall cost of government administration low when the business need to access such expertise is temporary — including where specialist ‘surge capacity’ is required to manage peak workloads — or where particular expertise is more efficiently obtained and maintained in a dedicated private sector business,” Cormann tells The Australian.

A third inquiry, established by Labor senator Deborah O’Neill to the Parliamentary Joint Committee on Corporations and Financial Services, goes to the heart of where the firms have come from and where their business models are taking them.

The powerful committee will examine the relationship between auditing and consulting services and potential conflicts of interests open to major auditing firms.

The Australian Securities & Investments Commission, which regulates auditors, has been warning of sliding audit quality since 2012 in a risk that former chairman Greg Medcraft has warned could result in an Enron-style corporate collapse.

The challenge for the big four will be to persuade MPs and senators that there is nothing to be concerned about in the face of growing criticism from former regulators and government transparency advocates.

Reinvigorated regulators

Shedding more light on their practices will be a gruelling task for the big four firms, which are used to operating behind the scenes. But they must also deal with a reinvigorated corporate regulator that is being urged to litigate more fiercely against instances of misconduct in the wake of a shellacking at the banking royal commission.

Indeed, the royal commission raised concerns about the relationship between large financial outfits and the big four firms, which often are engaged to review compliance on behalf of the regulator. Kenneth Hayne’s financial services royal commission heard how insurance giant Allianz asked Deloitte to retract a report that heavily criticised the company’s culture and compliance systems and how the same company pushed EY to revise a 2017 report to be more favourable to the insurer.

Allan Fels, the inaugural chairman of the Australian Competi­tion & Consumer Commission, says auditors — supposedly the “stewards” of capitalism — are failing in their legal requirement to provide assurance that corporate financial statements give an accurate and fair view of a company’s financial position, liabilities, and profits and losses. This, he argues, is because the big four audit firms are also collecting hundreds of millions each year in lucrative “non-audit” work, such as consulting, regulatory assurance, tax advice and management services.

“The Hayne royal commission showed big businesses don’t handle conflicts that are built into their operating structures well, and I fear that this is happening with auditing,” Fels says.

ASIC, which in its most recent audit review found inadequate work had been done in 20 per cent of examined areas of financial accounts, was recently found in a Treasury review of auditor disciplinary processes to have not tackled misconduct as forcefully as it could. ASIC had referred only six matters to the Company Auditors Disciplinary Board in the past eight years and took only one matter to court, and the Financial Reporting Council found ASIC’s audit inspection regime was geared towards education rather than enforcement, the Treasury review found.

But with the recent strengthening of penalties in the Corporations Act, after decades of having only weak fines to mete out, ASIC has been spurred into action to look for what insiders says are “egregious” examples of misconduct in auditing to test the law in the courts.

The government also is considering empowering the regulator to siphon remediation out of the firms for defective audits, and has instructed ASIC to look at instances of potential breaches from its audit inspection program to take to court.

Any move towards enforcement will be an abrupt change for the big four, which have enjoyed a largely uninterrupted rise through corporate Australia. While there are competition issues with only four companies controlling 95 per cent of the audit market for public companies, the ACCC this year neglected to pursue a Labor-backed cartel probe into the big four, following suggestions the chief executives of the firms had met for two private dinners.

“Conflicts, alone, however, are not sufficient to amount to a breach of the law,” ACCC chairman Rod Sims said.

ASIC, on the other hand, is aware that it must be seen to be enforcing a high standard of audit quality. If the truth of financial accounts can’t be guaranteed because mistakes are too common, the cost of capital will rise for all companies. ASIC’s current examination of about 65 financial accounts a year for its audit quality inspection review suggests the regulator lacks the proper funding for a more thorough examination.

The rise of non-audit work being carried out for audit clients is an issue at the top of the agenda for the parliamentary inquiry and for ASIC. The share of overall revenue at the big four from audits of financial statements has shrunk from an average 24 per cent to 18 per cent during the past five years.

Still, there are concerns that forcibly preventing the big four from providing extra services to their audit clients — which they have agreed to in Britain but nowhere else — may result in the firms putting more energy into marketing their services. This could risk a race to the bottom in a market where bread-and-butter audit work is already seen as a loss leader for more glamorous work.

Former competition watchdog Graeme Samuel isn’t interested in forcibly breaking up the big four firms — “structural change for structural change’s sake” — but says bringing more transparency to instances of poor work will help sort out the market. “A negative review has its own implications for the firm concerned,” Samuel says. “Ultimately the client will turn around and say: ‘Your reputation for intellectual integrity is so damaged that I think my company will suffer as a result and therefore I’m going to change audit.’ That’s the way it should work.”

Wherever the parliamentary inquiries eventually head, it’s unlikely to be an “annus fantasticus” for the big four.