EX­PEC­TA­TION GAP

Financial Mail - - FEATURES - War­ren Thomp­son thomp­sonw@busi­nesslive.co.za

Source: “Cor­po­ra­tions and Eco­nomic Crime: The Au­di­tors”, Open Se­crets, June 2020

The fu­ture of the au­dit in­dus­try hangs in the bal­ance, as a raft of in­dis­cre­tions and, in some cases, fla­grantly crim­i­nal ac­tiv­ity, has tar­nished an in­dus­try crit­i­cal to SA’S in­vest­ment rep­u­ta­tion.

This week, ad­vo­cacy group Open Se­crets pub­lishes a sear­ing re­port into the prac­tices of “the big four” — KPMG, Deloitte, EY and PWC — dis­man­tling the no­tion that the au­di­tors have been un­fairly crit­i­cised for their fail­ures, and set­ting out just how it be­lieves the pro­fes­sion must be re­formed.

In SA, th­ese fail­ures in­clude:

● Stein­hoff, au­dited by Deloitte, which failed to de­tect a R106bn fraud over more than a decade. Says Open Se­crets: “It is hard to ac­cept that an alert ex­ter­nal au­di­tor, us­ing the proper stan­dard of pro­fes­sional scep­ti­cism and com­mon sense, and with in­sight into all of Stein­hoff’s ac­counts, should not have raised red flags ear­lier.”

● VBS Mu­tual Bank, au­dited by KPMG, where more than R2bn was stolen in a crude scheme. KPMG’S lead au­di­tor on the VBS ac­count, Sipho Mal­aba, was ar­rested last week. He is said to have re­ceived R33.9m to hide the hole in VBS’S ac­counts — money he al­legedly used to buy Land

Rovers, prop­er­ties and pay off debt.

● SAA, where PWC failed to pick up mis­state­ments over a num­ber of years.

● The firm, and part­ner Nkonki, were paid R19m for this, but were only fined R200,000 by the reg­u­la­tor.

● Ton­gaat Hulett, where Deloitte missed that the sugar com­pany’s as­sets, in­clud­ing sugar cane, were over­stated by more than R10bn.

● Nu­mer­ous state en­ti­ties, in­clud­ing Eskom, where Deloitte earned R207m based on an ir­reg­u­lar con­tract, and the SA Rev­enue Ser­vice, where KPMG pro­duced an er­ro­neous “rogue unit re­port” that was used to fire 50 se­nior of­fi­cials.

Look­ing fur­ther afield, PWC acted as au­di­tor and con­sul­tant for So­nan­gol, the An­golan gov­ern­ment-owned oil com­pany “which was used by Is­abel dos San­tos to se­crete away bil­lions from the An­golan fis­cus through a network of 400 shell com­pa­nies”.

The real cri­sis, says Open Se­crets, is ac­count­abil­ity.

“Where large con­sul­tan­cies and au­dit firms are im­pli­cated in wrong­do­ing at sta­te­owned en­ter­prises, di­rec­tors and part­ners qui­etly exit their firms and some or all of the il­le­git­i­mate fees are paid back, but there is no hard ac­count­abil­ity for those re­spon­si­ble,” the re­port says.

One rea­son for this, it ar­gues, is that the “big four” form a “quasi-car­tel” that has made gov­ern­ments fear­ful of de­mand­ing real ac­count­abil­ity, lest one of them fail.

As it is, th­ese four au­dit firms ser­vice 497 of the largest 500 com­pa­nies on the New York Stock Ex­change, while in SA, 96% of all the com­pa­nies listed on the JSE are au­dited by one of the big four.

But the ten­ta­cles go deeper. A quar­ter of the JSE’S top 40 largest com­pa­nies have “ap­pointed in­di­vid­u­als who were pre­vi­ously em­ployed by their ex­ter­nal au­di­tors as chair­per­son of their au­dit com­mit­tees”.

And, when one au­di­tor fails to de­tect fraud, “it is an opportunit­y to cash in for those se­lected to clean up af­ter­wards”.

This was the case at Stein­hoff and Ton­gaat, where Deloitte failed to de­tect fraud, yet PWC was hired as a “foren­sic in­ves­ti­ga­tor” to find out what went wrong.

The irony is that “PWC it­self has been im­pli­cated in nearly iden­ti­cal fail­ures else­where,” says Open Se­crets.

PWC was paid €35m (R682m at today’s ex­change rate) to wade through the Stein­hoff fraud.

And, when au­di­tors are fi­nally held to ac­count, the penal­ties levied by the In­de­pen­dent Reg­u­la­tory

Board for Au­di­tors (Irba) are

What it means:

“usu­ally in­signif­i­cant com­pared to the prof­its th­ese firms con­tin­u­ously amass, or even to the amount made from the con­tract in ques­tion”.

Not a new phe­nom­e­non

But it’s not just in SA. Calls for re­form have also been heard in the UK, where an in­de­pen­dent re­view of the qual­ity and ef­fec­tive­ness of the pro­fes­sion was con­ducted by Sir Don­ald Bry­don, who pub­lished his find­ings in De­cem­ber last year.

Michael Marchant, who co-au­thored the Open Se­crets re­port with Mamello Mosiana, tells the FM: “In our on­go­ing in­ves­ti­ga­tion into state cap­ture, the au­di­tors kept on pop­ping up all over the place, so we de­cided it would be worth­while to probe them.”

But if the re­cent col­lapses sug­gest a pre­vi­ously highly re­garded in­dus­try which has sud­denly and trag­i­cally lost its way, don’t be fooled.

Khaya Sit­hole, a char­tered ac­coun­tant and aca­demic, says the coun­try’s au­dit stan­dards were de­clin­ing long be­fore the re­cent wave of scan­dals, pre­dat­ing SA plum­met­ing down the World Eco­nomic Fo­rum’s au­dit­ing rank­ings.

“The in­spec­tions re­port by Irba shows the au­dit qual­ity has been de­clin­ing over time,” says Sit­hole. “It’s only in the past two or three years that the vis­i­bil­ity has been am­pli­fied, as some of the high-pro­file cases have come to the pub­lic’s at­ten­tion.”

Mosiana says dis­turbingly there were com­mon el­e­ments to many of th­ese ac­count­ing scan­dals. “Un­der­stand­ing the cul­ture and re­mu­ner­a­tion struc­tures is key, and it ap­pears that keep­ing a client [and the con­comi­tant rev­enue stream] was in most cases a big­ger mo­ti­va­tion [than] act­ing hon­estly or truth­fully,” she says.

Sit­hole agrees, say­ing in the hurly-burly of pro­fes­sional relationsh­ips, where di­ver­gent opin­ions ex­ist, the big con­cern has been that au­di­tors are un­der ex­tra­or­di­nary pres­sure to hang onto their clients.

“When there is a dis­agree­ment on an is­sue, the au­di­tor has to de­cide whether this one is­sue is so con­tentious it is worth los­ing the relationsh­ip over, and if the au­di­tors con­cede, that is the point where things start to es­ca­late,” says Sit­hole.

The re­cent spate of scan­dals has, at least, led to soul search­ing by the in­dus­try.

Deloitte CEO Lwazi Bam tells the FM: “We felt as an au­dit pro­fes­sion we needed to do our own in­tro­spec­tion and iden­tify the is­sues in the pro­fes­sion that have led to the poor out­comes, as well as gen­er­ate our own re­sponses to re­form­ing the in­dus­try.”

This led to the cre­ation of the SA Au­dit­ing Pro­fes­sion Trust Ini­tia­tive, whose com­mit­tee com­prises se­nior ex­ec­u­tives from across the in­dus­try. It’s been tasked with rec­om­mend­ing an ap­pro­pri­ate, re­spon­sive plan to re­build trust in the pro­fes­sion.

Ex­pec­ta­tions gap

Any re­form of the in­dus­try will have to se­ri­ously tackle the “ex­pec­ta­tions gap”.

As Bam ex­plains, this is the gap be­tween what the pub­lic ex­pects of au­di­tors, and what they’re ac­tu­ally re­quired to do. It’s an is­sue ex­plored in depth in the Bry­don re­port.

The crux is this: as the cases of VBS, Stein­hoff and Ton­gaat show, the pub­lic ex­pects au­di­tors to be able to flag fraud and cor­rup­tion; but au­di­tors say they’re not trained to do this.

Says Bam: “There is a con­sid­er­a­tion of whether an au­dit scope should be ex­tended to in­clude fraud, and the scope of fraud.

If the ul­ti­mate ob­jec­tive is to re­duce cor­po­rate fail­ure through fraud, then the whole ecosys­tem needs to be changed along with the scope of the au­dit and the role of au­di­tors.”

Mark Ste­wart, who heads au­dit firm BDO in SA, agrees, but says that maybe it’s the right time to reimag­ine what the in­dus­try should be.

“The au­dit­ing stan­dards are spe­cific and I don’t think as an in­dus­try we have made any progress in ed­u­cat­ing con­sumers about the is­sue. But per­haps we should start with what the ex­pec­ta­tions are, and build from there, and this may well change the pro­fes­sion as we know it.”

This would im­ply a com­plete re­build­ing of the ecosys­tem: re­vis­ing in­ter­na­tional ac­count­ing stan­dards, the role of boards, and the role played by reg­u­la­tors.

How­ever, Open Se­crets be­lieves that au­di­tors use this “ex­pec­ta­tion gap” as an ex­cuse for fail­ing to de­liver on the le­git­i­mate ex­pec­ta­tion that they’re meant to en­sure cor­po­rate fi­nan­cial pro­bity.

“Au­dit­ing should be un­der­stood as a so­cial util­ity, given that it is a vi­tal check on ac­count­ing abuses to pro­tect the pub­lic at large. We should there­fore re­ject the ar­gu­ment that pub­lic anger at au­dit fail­ures is mis­placed be­cause the pub­lic ex­pects more than au­di­tors can de­liver,” the re­searchers write.

Rather than an “ex­pec­ta­tions gap”, there is an “ac­count­abil­ity gap”, they say.

Crit­ics add that it’s not even that au­di­tors aren’t de­tect­ing fraud, they aren’t even main­tain­ing a “healthy pro­fes­sional scep­ti­cism”, as they are meant to do — which cre­ates an en­vi­ron­ment in which fraud can thrive.

One in­ter­ven­tion meant to re­store “pro­fes­sional

scep­ti­cism” was the idea of manda­tory au­dit firm ro­ta­tion, which in SA meant re­quir­ing a com­pany to swap au­dit firms once a decade so their ac­counts can be scru­ti­nised by a fresh pair of eyes.

A strong point in the case for ro­ta­tion is Ton­gaat Hulett. Here, Deloitte has been the sugar com­pany’s au­di­tor for 82 years.

Still, when Irba man­dated au­dit firm ro­ta­tion back in 2017, it was met with mixed reaction.

But Sit­hole agrees with the de­ci­sion. “I think a new set of eyes asks new ques­tions, and a new broom has a bet­ter abil­ity to sweep clean. It’s just a fact that there is bias when you have known a client for a long time,” he says.

The ro­ta­tion also had a de­vel­op­men­tal ob­jec­tive that would pro­mote ac­cess to “next-tier and black-owned firms,” which op­er­ate un­der the top tier of the big four.

By the end of April, Irba says, one-quar­ter (91) of Jse-listed com­pa­nies had ro­tated firms.

Sit­hole agrees that with­out in­ter­ven­tion, mar­ket con­cen­tra­tion could never be ad­dressed. “It could be trans­for­ma­tional, but there aren’t enough black play­ers of scale at the mo­ment [to com­pete for the big au­dits] and, in any event, they could get bought out or merge with an­other com­pany as hap­pened with SNG Grant Thornton.”

A con­flicted busi­ness model

An­other big is­sue flagged by Open Se­crets is that of the $134bn earned by the big four au­dit firms glob­ally in 2017, the bulk came not from au­dit­ing, but from “con­sult­ing”.

This has led to a con­fused man­date, mud­dy­ing the pic­ture in the pub­lic mind. And this re­liance on con­sult­ing ser­vices has come even as firms’ “abil­ity to pro­vide ac­cu­rate au­dit­ing ser­vices is in de­cline”.

The so­lu­tion, say many, is to re­quire firms to split into con­sult­ing and au­dit­ing com­pa­nies.

It’s an old script though. When US en­ergy gi­ant En­ron folded in 2001, de­stroy­ing

Arthur An­der­sen, one of the five largest au­dit/con­sult­ing firms in the world, the de­bate re­ally took off.

Bernard Agul­has, the out­go­ing CEO of Irba, makes it patently clear where he stands on the is­sue: the sep­a­ra­tion of au­dit from non-au­dit ser­vices would be “a huge step” in im­prov­ing au­di­tor in­de­pen­dence.

“While au­dits are per­formed to serve the pub­lic and share­hold­ers, con­sult­ing ser­vices are de­liv­ered to sat­isfy the client. Where the con­sult­ing ser­vices start to ex­ceed the au­dit ser­vices, au­dit qual­ity might be ne­glected in favour of se­cur­ing con­sult­ing fees,” he says.

Non-au­dit ser­vices can range from de­sign­ing and im­ple­ment­ing a new soft­ware sys­tem, to con­sult­ing on ways for a com­pany to win mar­ket share in an in­dus­try.

The au­dit com­pa­nies, un­der­stand­ably, are less than en­thu­si­as­tic about the pro­posed sep­a­ra­tion.

“At the mo­ment we think there are suf­fi­cient safe­guards in place to pre­vent con­flicts of in­ter­est, which are com­mon across the pro­fes­sion,” says Bam.

“There are reg­u­la­tions that ap­prove how much non-au­dit ser­vices are pro­vided to a client and the ul­ti­mate ap­proval for this work is given by the au­dit com­mit­tee. It is un­likely an au­dit client would ap­prove a large non-au­dit-re­lated con­sult­ing con­tract.”

BDO says its busi­ness is pri­mar­ily au­dit­ing — and it sim­ply doesn’t do con­sult­ing work for com­pa­nies it au­dits.

Ste­wart sug­gests a third op­tion. In­stead of forc­ing con­sult­ing/au­dit com­pa­nies to choose what they want to be, which would en­tail sell­ing one half of the busi­ness, rules could be put in place pre­vent­ing firms from au­dit­ing and con­sult­ing to the

Source: “Cor­po­ra­tions and Eco­nomic Crime: The Au­di­tors”, Open Se­crets, June 2020 same com­pa­nies.

“It has to be very clearly de­fined and leg­is­lated. If it is left to the dis­cre­tion of the firm, it could be­come messy and it goes back to the pub­lic per­cep­tion — how do we make it clear they are in­de­pen­dent and do­ing what they are sup­posed to do,” Ste­wart says.

Re­form

But if ev­ery­one knows what the prob­lems are, there’s lit­tle con­sen­sus on ex­actly how to fix them.

In De­cem­ber, Bry­don re­leased his re­port about re­form in the UK, which is likely to pro­vide a tem­plate for how SA re­forms its au­dit­ing pro­fes­sion.

Bry­don says the in­dus­try needs to go back to first prin­ci­ples, and re­con­sider how an au­dit is even de­fined.

His def­i­ni­tion is this: “The pur­pose of an au­dit is to help es­tab­lish and main­tain de­served con­fi­dence in a com­pany, in its di­rec­tors and in the in­for­ma­tion for which they have re­spon­si­bil­ity to re­port, in­clud­ing the fi­nan­cial state­ments.”

If you in­ter­pret this widely, it could cer

tainly sug­gest an ex­ten­sion of their role to in­clude de­tect­ing fraud, since this is ev­i­dently what the pub­lic now ex­pects.

Bry­don also sug­gests di­rec­tors should be re­quired to state, each year, that the fi­nan­cial ac­counts are fairly pre­sented in all ma­te­rial re­spects — and there should be per­sonal li­a­bil­ity if this proves not to be true.

And he sug­gests fi­nan­cial ac­counts in­clude a “re­silience state­ment”, in which au­di­tors would have to give their opin­ion on risks to that com­pany’s go­ing-con­cern sta­tus, and dis­close all in­for­ma­tion that might con­tra­dict their opin­ion.

When it comes to fraud, he rec­om­mends im­pos­ing a duty on di­rec­tors that obliges them to set out what ac­tions they took each year to de­tect and pre­vent fraud. And an “au­di­tor fraud panel” would be set up to judge au­di­tors’ cul­pa­bil­ity in any fraud.

Th­ese ideas are likely to find their way into SA’S re­forms too, so it would be wise for firms to con­sider how prac­ti­cal they might be.

Open Se­crets ar­gues there is no “sin­gle change” that can re­form the pro­fes­sion, but rather a se­ries of so­lu­tions to dis­rupt the sta­tus quo and en­sure bet­ter ac­count­abil­ity.

The first is to take the leap and defini­tively split au­dit­ing firms from con­sult­ing firms; the sec­ond is to boost the power of the reg­u­la­tor and re­quire more trans­parency; and the third is to re­quire the au­di­tor-gen­eral to play a far greater role in mon­i­tor­ing the au­dits of pub­lic en­ti­ties.

It be­lieves “more ef­fec­tive and in­tru­sive state reg­u­la­tion”, along with “re­build­ing the ca­pac­ity of state agen­cies tasked with in­ves­ti­gat­ing and prose­cut­ing fi­nan­cial and eco­nomic crimes” would go a long way to fix­ing the prob­lem.

Irba, it ar­gues, needs to have far more clout in hold­ing au­di­tors to ac­count, but it must also be more trans­par­ent with the pub­lic. “Vague news­let­ters and the re­fusal to name names — a re­cur­ring theme in the case stud­ies — un­der­mines the sanc­tion and pre­vents other ac­tors from mak­ing in­formed de­ci­sions,” it says.

Irba it­self, how­ever, is cur­rently mired in a lead­er­ship cri­sis (see page 4) af­ter hav­ing ap­pointed Jenitha John to re­place Agul­has from this month. While John has im­pres­sive cre­den­tials, she was also the chair of Ton­gaat’s au­dit com­mit­tee when that fraud was com­mit­ted. Though she isn’t im­pli­cated, she did have the duty of over­sight.

As Open Se­crets points out, she’ll also have the job of head­ing Irba, which will have to ad­ju­di­cate whether Deloitte messed up at Ton­gaat.

Sit­hole says, as it stands, Irba isn’t prop­erly equipped for the job at hand. “We are still lack­ing the in­sti­tu­tion that can do that. The other prob­lem is that re­ports are not pub­lic so it’s hard to tell what Irba pro­vides to the au­dit com­pa­nies. So I think Irba can play a much more con­struc­tive role” he says.

How­ever, in its re­port, Open Se­crets sounds a warn­ing about the re­form process, say­ing: “If we are go­ing to re­form au­dit­ing, then there’s one les­son to learn from the fi­nan­cial cri­sis: don’t trust the au­di­tors to do it.”

At this point, few mem­bers of the pub­lic would. But au­di­tors should em­brace th­ese re­forms: it’s the only way for them to re­build their le­git­i­macy.

Source: “Cor­po­ra­tions and Eco­nomic Crime: The Au­di­tors”, Open Se­crets, June 2020

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