When investors decide to put money into
a company, chances are they’ve looked at its financial statements, which contain audited
reports of the organization’s accounts, giving them the confidence
to part with their money. For a majority of large, publicly traded companies,
these audits are conducted by one of the Big Four accounting firms:
KPMG, PWC, EY and Deloitte. But their dominance is
under threat from regulators. Following the collapse of some high-profile
companies, scrutiny is on the conflict of interest between the accounting industry’s
audit and non-audit services. It’s led to calls from the public, politicians
and regulators for the break-up of the Big Four and a shakeup of
the accounting industry. In 2001, energy company Enron collapsed amid accusations of accounting fraud, which was at the time, the largest corporate
bankruptcy in U.S. history. The demise of a publicly listed company that
was worth over $60 billion left many asking how the firm’s auditors, Arthur Andersen,
could have signed off on accounting books that overstated the energy
giant’s profitability. Arthur Andersen ended up being another casualty
of the scandal, convicted of obstructing justice and losing the right
to file accounts. Less than a year after its conviction, the
fate of America’s oldest accounting firm was effectively sealed, even though the
Supreme Court later overturned the ruling. Andersen’s firms around the world were then
sold off to members of what became the Big Four. But before the emergence of the Big Four,
the market for audit services was dominated by eight companies that were created through
alliances across the Atlantic and beyond. Along with Arthur Andersen, the eight included
Arthur Young, Coopers & Lybrand, Deloitte Haskins & Sells, Ernst & Whinney, Peat Marwick
Mitchell, Price Waterhouse, and Touche Ross. The Big Eight, as they were known, grew rapidly
amid a wider consolidation within the industry, including smaller firms like KMG which merged
with Peat Marwick to eventually become KPMG. Marketed as modern, global business networks,
competition between the eight intensified as they expanded
internationally. By 1989, the Big Eight started to whittle
down further when Arthur Young combined with Ernst & Whinney while Deloitte Haskins & Sells
merged with Touche Ross to form Deloitte & Touche, usually referred
to as Deloitte. The Big Six became the Big Five in 1998 when
Price Waterhouse merged with Coopers & Lybrand to form PricewaterhouseCoopers,
now known as PwC. And when Arthur Andersen collapsed,
the Big Five became the Big Four. Their dominance of the
industry has grown ever since. In 2019, the Big Four had more than 75% of
the global accounting market share, nearly a 10 percentage point increase from the year
before, while their revenues during that financial year exceeded
$154 billion. The group also has a lock on the
world’slargest public companies. In 2019, just five of the 500 companies in
the S&P stock market index were audited by a non-Big
Four firm. In the U.K., all companies that make up the
FTSE 100, the country’s blue-chip index, were audited by one
of the Big Four in 2018. This collective dominance is one reason why
regulators are attempting to prise the audit market open to tougher
scrutiny and fresh competition. Critics of the Big Four also point out that
despite all their resources, including over a million employees, there have been several
high-profile failures to uncover massive frauds. A few months after Enron filed for bankruptcy,
a bigger accounting scandal involving U.S. telecommunications company WorldCom erupted,
this time ensnaring KPMG, who took over the accounting books from the
embattled Arthur Anderson. While the Big Four managed to emerge relatively
unscathed, more accounting scandals continued to rock investor confidence
in the years ahead. I wouldn’t hire you, to do an audit
of the contents of my fridge. These include the demise of Lehman Brothers
in 2008, which was audited by Ernst & Young, now known
as EY, Lehman has lost – you can see
right there – 36% of its value. The insolvent construction giant Carillion,
which counted Deloitte and KPMG as its auditors, We were a customer of Carillion,
not the manager of Carillion. Tour operator Thomas Cook, whose accounts
were signed off by PwC and EY, and the 1MDB scandal, which tainted three
of the Big Four firms. In 2020, German regulators examined EY for
approving the accounts of online payments company Wirecard, for more than ten years,
before it filed for insolvency. Critics believe they avoid properly scrutinizing
their clients’ accounts because this could threaten their consultancy work. Along with auditing, the Big Four offer other
services such as management consulting, taxation, market research and
legal advisory services. In fact, these non-audit services provide
the lion’s share of the Big Four’s income. In the U.K., only a fifth of the Big Four’s
total revenue is generated from auditing. In the case of Enron, Arthur Andersen was
earning more from the consulting services it provided to the energy firm than
it did from its auditing activities. Critics also claim that the strong growth
of the non-audit business, which resulted from changes in the business environment for
accounting firms in the 1970s, has impaired the robustness and
objectivity of audits. While the standardized approach to audits
ensures that financial statements are fairly stated without material discrepancies, and
that appropriate internal controls are in place, this has led to a mismatch in the
expectations and limitations of audits. In fact, a study of nearly 2,700 cases of
workplace fraud in 125 countries found that a majority are uncovered through tip-offs
— showing the importance of whistleblowing hotlines — as opposed to
internal or external audits. The Big Four insist, however, that regulations
restricting consultancy work are sufficient to protect the independence
of their auditing services. These include the Sarbanes–Oxley Act of
2002 in the U.S., and Japan’s Financial Instruments and
Exchange Act. In the U.K. and EU, auditors are not allowed
to provide consulting advice to businesses one year leading up to and during
the term of an audit contract. Companies included in the FTSE 350 Index,
the 350 Biggest companies in the U.K., must also put their audit out for tender every 10
years and must change auditors every 20 years. However, these restrictions, according
to regulators, aren’t fool proof. When an auditing contract ends, the firm can
immediately begin doing consultancy work for the same company, making it less likely for
existing auditors to challenge a client if it jeopardizes future contracts
for lucrative non-audit work. Some politicians also argue that these regulations
are overly complex and hinder competitiveness. Even with more regulatory paperwork and longer
annual reports, these accounting scandals have not
abated. There are signs, though, that the Big Four realize
that the status quo cannot continue forever. Deloitte has set up an audit governance board,
which it claims will “focus on the policies and procedures for
improving audit quality.” And EY, in the wake of the Wirecard scandal,
has told its clients that auditors should play a bigger role
in detecting fraud. The U.K.’s accounting regulator, the Financial
Reporting Council, has also set a 2024 deadline for the Big Four to separate their audit units
from their other services, although the watchdog stopped short of demanding a full,
structural break-up of the firms. The Big Four, in response to queries from
CNBC, said that they have taken steps to enhance audit governance, including engaging with
the Financial Reporting Council on the principles of operational
separation. Audits serve a crucial role in instilling
public confidence in financial markets. Yet, the same costly errors that resulted
in the demise of Arthur Andersen nearly twenty years ago are still
happening today. Unless the industry can restore confidence
that their audits are independent, objective and uncompromised, the pressure will build
on regulators to act before the financial world is engulfed in yet
another accounting scandal. Hi guys, thanks for watching our video.
I briefly mentioned Wirecard in this story. We made another explainer on that
scandal specifically so do check that out and we'll see you next time.
