The Button-Down Mafia: How the Public Accounting Firms Run a Racket on Investors and Thrive While Their Clients Fail
There's a popular Sicilian proverb:
Cu è surdu, orbu e taci, campa cent'anni 'mpaci.
"He who is deaf, blind, and silent will live a hundred years in peace."
Enron, WorldCom, HealthSouth, Tyco, Parmalat, Adelphia, AIG...You would think enough lessons had been learned. The financial markets are a mess and the capitalist system threatened. The systems in place to anticipate and preempt market risk failed completely. Financial firms leveraged their capital to an unprecedented extent with no checks and balances. Companies took on enormous risks with minimal disclosure to their shareholders.
And the largest global public accounting firms -- KPMG, PricewaterhouseCoopers, Deloitte, and Ernst & Young -- again failed to prevent, warn, or mitigate the desperate financial situation, the national crisis of significant proportions we now find ourselves in.
"...There were systematic failures in the checks and balances in the system, by Boards of Directors, by credit rating agencies, and by government regulators..."
Even the US Treasury Secretary doesn't hold the public accounting firms accountable for the problems we now face. The Big 4 public accounting firms haven't yet been asked the hard questions by governments, legislators, or regulators.
They're getting a free pass.
The global public accounting firms have worldwide, government-sanctioned franchises as market watchdogs. They are supposed to be working to protect shareholders' interests. Financial statement audits are required by most global exchanges -- to provide a seal of approval on the financial disclosures of public companies. The accounting firms employ accountants, licensed by local authorities and trained as auditors. These "professionals" audit the financial statements of public and private companies, governments, and not-for-profit organizations worldwide. Public accountants must express an opinion on those financial statements.
In the United States, certified public accountants are the only authorized non-governmental type of external auditors who may perform audits of financial statements and provide reports of those audits for public review, submission to the SEC, and to comply with exchange listing standards. In the United States, the firms and their licensed professionals are required to be independent of the entities being audited.
The Big 4 public accounting firms are very big business themselves. As an industry, the top firms generate more than $100 billion in total revenues globally and employ hundreds of thousands of people. As auditors and advisors, they work inside the banks, brokerage firms, auto manufacturers, mortgage brokers, and homebuilders. They're "in the know" about every public company and most large private companies, earning millions of dollars in fees, for audit opinions that have ultimately proved worthless. They were right there in the boardrooms when the US government took over Fannie Mae, Freddie Mac, and AIG. They are still at executives' right hands, earning more fees helping the US federal government under TARP to organize and control the taxpayers' new investments in subprime loans, non-liquid assets, and exotic financial instruments. The public accounting firms make money whether companies thrive or whether they fail. The Big 4 firms are now charging billions to advise each other's clients as those companies file for bankruptcy protection.
According to a study by David L. Carter, Ph.D. at Michigan State University's School of Criminal Justice, the basic characteristics of organized crime are:
• Profit accumulation • Longevity • An organizational structure that facilitates criminal activity • Efforts to corrupt government officials, police, and corporate official • The use of violence
Profit accumulation
Big 4 firms continued to see significant double-digit growth in top line revenue during 2007-2008, even though the recession had already started. Who else besides pimps, loan sharks, and illegal gambling had such a great year last year? Such monopolistic growth and profit is due in large part to the lack of competition within the industry. The largest four global public accounting firms audit almost 99% of public company revenue in the United States and all but one of the UK's top 350 companies.
Since the passing of the Sarbanes-Oxley legislation in 2002, public companies have complained that audit fees have tripled or even quadrupled. They are still increasing, albeit at a slightly decreasing rate. But the combination of mandated audits and the addition of Sarbanes-Oxley requirements prompted many companies to use words like "extortion" and "protection money" to describe their feelings regarding the cost of pieces of paper that seemed to provide so little tangible value to shareholders. Paying for an audit, defined as broadly by the auditors as they chose, became an "offer you can't refuse."
Longevity
The Big 4 public accounting firms are loose confederations, combinations of firms, many of which started all the way back in the late 19th Century. Firms have merged and grown, some dying along the way, and others becoming predators of the weaker ones. The largest four firms compete on paper, yet coexist in a cooperative manner -- much like the five New York City crime families: the Bonannos, the Colombos, the Genoveses, the Gambinos, and the Luccheses -- in order to achieve common objectives via industry lobbyists such as the Center for Audit Quality.
An organizational structure that facilitates criminal activity
The public accounting firms are organized as partnerships, like law firms. They recruit and promote less like a business, based on merit, and more like a secret society or fraternity.
"Becoming a made member of La Cosa Nostra requires serving an apprenticeship and then being proposed by a Boss. This is followed by gaining approval for membership from all the other families."
Acceptance and success in the Big 4 public accounting firms requires selection based on university credentials, referrals from professors, family background, and business ties, as well as having political beliefs and economic philosophies that are aligned with firm values. Internal operations are conducted in a secretive manner. Financial results and common business metrics are minimally disclosed to the outside and on a "need to know" basis internally.
There's a type of Big 4 omertà, the extreme form of loyalty and solidarity in the face of authority usually attributed to the Mafia. Once initiated into firm culture, survival requires adoption of this informal oath of allegiance that makes it shameful to betray even one's deadliest enemy, your competitors, to legal and regulatory authorities. Examples of this extreme sense of loyalty to even those who've disgraced the profession can be found when partners that have been sanctioned by the SEC, forbidden to audit public companies, are later reinstated by the SEC. Deloitte, for example, maintained the partners responsible for Adelphia and Navistar on their payroll during their SEC suspension and they lived to audit another public company another day.
Efforts to corrupt government officials, police, and corporate officials
All the public accounting firms spend a lot of time and money publicizing their good works. There's a ton spent on volunteerism and donations to foundations. There's a press release a day about some or another warm and fuzzy diversity initiative in spite of the documented lack of progress in getting women and minorities to partner positions in proportion to their numbers in universities and entry level positions. They spend a bucketful of money to erase the fact that they're otherwise sucking money out of the economy for essentially worthless audit opinions.
There's also a big spend on political campaigns. For example, all of the US based public accounting firms like US Senator Christopher Dodd. It's not the man, his party, or his politics, but his position that attracts the dollars. The Chairman of the Senate Banking Committee has significant influence over the legislation affecting the Big 4 public accounting firms.
Another big recipient of the audit firms' largesse is US Senator Charles Schumer. Early in the subprime crisis, he was heard demanding action from, of all people, the accounting firms. This is comical. After all, the public accounting firms pay Schumer to protect their interests, not the other way around. Ernst & Young is one of his all time career big donors. Deloitte is one of his largest campaign contributors. As a matter of fact, E&Y and Deloitte are in his top 20 all time greatest contributors.
The use of violence
Violence is the only thing left that the firms haven't depended on to accomplish their goals. That we know of... However, their labor practices have been the subject of class action lawsuits in the US and Canada during the last few years. It appears they do not pay overtime when they should and work their professionals like the interns on TV's ER.
We've all seen what sleep deprivation can to do the quality of medical care. Imagine what being overworked and underpaid does to the quality of accounting and audit work performed by thousands of new college graduates hired each year. These are the foot soldiers doing the hands-on work to insure the accuracy of the financial information published by your employer or the companies in your 401k. There's even a case from 2007 when a poor young woman in Romania working for Ernst & Young died from exhaustion. She was working long hours without rest under pressure to keep her job.
The Ratings Agency Circle Jerk
Controlling and making money from all sides of a transaction is another potential sign of a criminal organization at work. In the aftermath of the financial crisis, the press, global legislative bodies, and regulators all got sidetracked by concerns over the issue of culpability of the ratings agencies. What they missed is the unholy alliance between the rating agencies, the auditors of the ratings agencies, the companies whose bonds were being rated, and the auditors of those bond issuers.
• The public accounting firms certified financial statements and gave clean audit opinions for companies that issued mortgages and mortgage-backed securities.
• The ratings agencies counted on these audit opinions and performed no further due diligence to ascertain those opinions were justified.
• The public accounting firms audit the ratings agencies. The three largest ratings agencies, Standard & Poor's (part of McGraw-Hill), Moody's, and Fitch (part of Fimalac, a French company) are all public companies that are required to have their financial statement audited by KPMG, PricewaterhouseCoopers, Deloitte, or Ernst & Young.
• The public accounting firms audited the failed companies that issued the mortgages such as New Century, Countrywide, Northern Rock, and American Home.
• They also audit the firms such as Bear Stearns, Citibank, Bank of America, and Merrill Lynch that created, marketed and invested in the packaged mortgage securities -- many of which ended up off balance sheets. And they audit the monoline credit risk insurance providers MBIA and AMBAC.
The public accounting firms and their hundreds of thousands of auditors should be an investor's first line of independent defense. But these firms turned a blind eye to the excesses, mismanagement, and fraud of executives managing their client firms. The public accounting firms issued clean financial opinions for all of the firms that eventually, most less than a year later, failed, were taken over, or nationalized. And the regulators slept.
There's something about the Big 4 public accounting firms, and to a lesser extent their next tier firm colleagues, that allows them to make money, to thrive, in spite of failure all around them. They continue on, oblivious to accelerating rates of litigation against them and the realistic threat of a catastrophic lawsuit.
Their solution to the legal threats resulting from their clients' frauds and failures?
Liability caps.
Governments all over the world are protecting and shielding the public accounting firms from failure under any circumstances, even in the face of repeated failure on their part. The current business model for global public accounting firms no longer promotes the safeguarding of shareholder interests in the modern publicly traded multinational. Shareholders, and other stakeholders, are being shafted. The firms and their partners may be corrupt. They are unequivocally self-interested.
When it comes to the Big 4 public accounting firms, the official word is still, "Too few to fail. Too powerful to call to account."
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I am a CPA with public accounting experience and integrity. I have worked as an independent consultant with Fannie Mae and Freddie Mac and many other firms and watched in horror as the big 4 representatives swaggered in like they owned the place. If the truth was told the resident knowledge that walks through a client door on any given day is extremely low.
I witnessed the interaction at Freddie Mac and Fannie Mae with their big 4 auditors, every bad accounting decision was vetted through their big 4 auditor. As a side, the regulators and in the case of Fannie Mae the SEC, were all “in on” the accounting treatments and had input on business decisions.
The big 4, the regulators and the SEC have not acknowledged their roles in relation to the current crisis. I’m surprised that there aren’t huge shareholder lawsuits!
I have had several other large clients and have watched in horror as 10-K after 10-K has been filed with erroneous information. The consuming public needs to be warned that they can not place reliance on the attestations of the big 4 CPA firms.
Anderson was punished was because their hubris was so blatant, I was in Houston during those days and personally witnessed the shredding “trucks” parked outside of their offices. And the beat goes on…, absolutely no accountability for the big 4 firms.
In re: PerDivertirsi's query 4:21 pm on 3/17/09 in which PD asks edwcorey "Do you have links to reports provided by Arthur Andersen's consulting division to Enron that showed 'how to circumvent the audits'?" and PD continues, "I assume a statement like this would be backed by facts that would presumably have been discovered during litigation
"Enron's original accounting treatment of the Chewco and LJM1 transactions that
led to Enron's November 2001 restatement was clearly wrong, apparently the result of
mistakes either in structuring the transactions or in basic accounting. In other cases, the
accounting treatment was likely wrong, notwithstanding creative efforts to circumvent
accounting principles through the complex structuring of transactions that lacked
fundamental economic substance. In virtually all of the transactions, Enron's accounting
treatment was determined with extensive participation and structuring advice from
Andersen, which Management reported to the Board. Enron's records show that
Andersen billed Enron $5.7 million for advice in connection with the LJM and Chewco
transactions alone, above and beyond its regular audit fees."
The problem is not with the audit firms, the problem is with the accounting rules. They are too complicated. The author also mentions the PCAOB. Based on my experience with my auditors i think the PCAOB has made them less effective since they are so concerned about getting a finding during a review by them that they lose focus on bigger issues but rather focus on making the documentation perfect. I think being an audit partner is one of the toughest jobs out there in accounting. They get it from all angles, PCAOB, Peer Review, SEC comments, etc.
They also struggle with public perception which thinks they are engaged to detect fraud which they are not. The author knows this but she is trying to make a living out of slandering the large firms. Again, everything is too complicated and the firms are not to blame. It would be like blaming a cop if you dont like the laws in place rather than your legislator
See Francine McKenna's Profile
Dear @confusedcpa
Do you know who makes the accounting/auditing rules? Not-so-independent standards boards, including the FASB, IASB, and PCAOB, that are chock full of former accounting firm partners. Maybe you should go back to making your documentation perfect. If the PCOAB is ineffective it's because what they do is hampered by the desire to not offend their former colleagues at the firms. Just ask Tom Ray, former Chief Auditor for PCOAB who's going back to his old firm KPMG. http://ret
"Slander" is a very big and important word. And since everything is too complicated for you, I suggest you don't go throwing such inflammatory words around. My purpose is not to cause confusion, but to dispel it. The accounting firms are in the middle of everything and playing all sides. More general business readers and investors should know and act on that fact.
Thank you for the eye opening article. I am very happy that there are intelligent people at last who can prove that auditing is to blame for the current mess the country is right now. I can finally see how this mess has nothing to do with the previous administration and the MEDIA. Thank YOU!
In Russia, they call it oligarchy. Crony capitalism, it was called in The Philippines under Marcos. It's nothing new to history. It will not last. But what are we building to take its place? Or do we even need auditors? How come threat of jail isn't enough to keep business people honest?
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@HapAckerly
When was the last time you saw an auditor go to jail in the United States? That's why the situation re: Satyam in India has scared the hell out of PwC.
http://ret
It's not necessarily the accountants that are to blame; it's the consulting arm of these companies that show the corporations how to circumvent the audits. It's what brought down Enron: the consulting arm of Arthur Andersen showed Enron how to evade the audit mechanism of Arthur Andersen's accountants.
edwcorey - Do you have links to reports provided by Arthur Andersen's consulting division to Enron that showed "how to circumvent the audits"? I assume a statement like this would be backed by facts that would presumably have been discovered during litigation. I don't believe Arthur Andersen could audit a company if another section of the same audit firm was providing consulting services to circumvent a financial statement audit, but I could be wrong. At a mimimum, it would be unethical, and would probably run afoul of some SEC rule. But please share the support for the claim.
This is a simple issue: it is not the auditor's job to tell investors if the company is a good investment. This is spelled out, in plain english, in the auditor's opinion. The auditors test a public company's (and private ones that require an audit) processes and transactions to detect any fraud (and it's impossible to identify 100% of business fraud during an audit) and make sure the financials conform to a set of accounting standards. That's it.
I don't think it's fair to intelligent but otherwise ignorant readers who don't understand the role of an independent auditor to tar an industry as "mafia". It's silly. Maybe I missed the joke?
The Big 4 firms are partnerships? And that is relevant because... because why? I noticed that your company is organized as an LLC. Care to share with the readers why you've chosen to limit your liability to the extent of your organization's net assets (most likely cash on hand, investments, and uncollected receivables)?
We have professionals who tell investors if a company is a good investment. They're called analysts. And if people don't like the analysts' opinions, then they should do their own research.
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@PerDivertirsi
It's not the auditor's role to tell investors if a company is a good investment. We agree. It is the auditor's role to give an opinion whether the published financial statements "present fairly, in all material respects, the consolidated financial position of X Company and the consolidated results of its operations and its cash flows for each of the X years in the period ended December 31, 200X, in conformity with U.S. generally accepted accounting principles
This audit is based on a verified framework of internal controls. So, you're going to tell me that investors in Bear Stearns, Lehman, New Century, Citibank, Bank of America, GM... are going to agree that their most recent financial statements as presented gave them a fair, complete, and valid representation of the financial condition of those companies, given what was to come in less than a years time after they were published? What assurances, exactly, did those companies' shareholders pay their auditors millions of dollars for?
My firm is currently me, myself, and I and others as needed based on the engagement. I'm a writer, teacher, public speaker first. I work to write, not the other way around. The net assets are negligible. I have very little to lose. I do not give audit opinions and I do not do any work that makes me vulnerable to liability beyond any insurance coverage I may have.
You believe the analysts' version of the truth? That's the ticket.
I pity the fool...
Ms. McKenna, thank you for your direct response. Given your prior experience, you know better than most that the issue lies not with the auditors but with FASB. Five of the six firms you listed in your reply are in the financial services industry, and the accounting rules that apply to banks and bank-like financial entities are not as good as those in other industries. Mark-to-market has become a highly politicized issue. Further, in many cases the auditors relied and continue to rely on the companies valuations because the financial instruments that are a large part of their balance sheets were practically unvaluable by a third party or a market, and a good portion were covered by various forms of insurance that turned out to be worthless, too. The auditors need look mainly to FASB for guidance.
The Going Concern threshhold is based not only on the current financial statements (retrospective, by the way) but also management reprsentations as to the direction of the broader market that they operate in for the near-term future. As long as it's plausible, there's not much an auditor can do.
I don't believe the analysts' version of the truth. I do my own research, but have to rely on the same set of financials that everyone else has to. If one no longer has faith in the financials of every company, then it is impossible to make an investment decision and we should stuff our cash into the mattress.
A basic principle of regulation has to be that if there is scope for moral hazard, there will be corruption. As in the case of the ratings agencies, the business model for auditors must be changed so that analysts are not paid by the firms they are assessing. Until that happens, no one should trust a thing any of them has to say. As William Buiter of MIT says, "Self regulation is to regulation as self-importance is to importance".
right -
as Woody Guthrie wrote, in the 1930s:
"As through this world you travel/ you'll meet some funny men
Some rob you with a six-gun/ and some with a fountain pen"
There was a time where ownership of land was the definer of wealth, now of course cash is king and the best way to control cash is the same as was the best way to control land, though government. In those days better the majority of the wealth was controlled by a small percentage of the population (generally the royalty). In a republic such as ours, the rich can use their money to control government though campaign financing, it is much less taxing and insures they wield power far longer than term limits would allow. In our time more than 38% of the wealth of our nation is controlled by 1% of the population. This wealth allows them to buy control in the form of direct contributions, and more importantly through media ownership. Imagine how easy it would be to control elections if everyday your company provided the public is messages designed to influence the viewers. One could even start a new business which cherry picks the news media and posts stories in a central site to promote a specific viewpoint. Of course this doesn't happen, I am just a paranoid crank.
Yet another set of bunglers to add to the "balls in the air" that we, the American people" are being asked to re-evaluate. Are these auditors innocent of any wrong doing? As they are hired to protect big business and assure that their books will "pass a gov't audit". The more convoluted the tax rules the easier it is for the auditors to help business game the system.
Soon, what we will all learn is that we need to be responsible for our actions and when someone starts trying to sell "snake oil" that we just say NO! We need to learn from this economic debacle is that there is a HUGE difference between wants and needs...an
Because GAAP now stands for Greed And Apathy Prevail.
Ms. McKenna, auditors ensure that financial statements conform to GAAP. But they can't guard against the financial ignorance of the population. It is easy to place broad labels on the accounting industry, but if want to truly make a critique of auditors you must first have some understanding of what auditors actually audit and what they don't. They determine whether those financial statements are in accordance with accounting standards. The problem at the banks were not the auditors, the banks books were in accordance with GAAP. Correct books however, does not mean a company is well run. The fact that the entire economy was overleveraged was not the auditors fault. Neither was the fact that the banks chose to make risky investments. Its easy to scapegoat now, to join the populist outrage for all that is financial. I work everyday at a big 4 firm; my colleagues are not rich, they are not making million dollar bonuses. They are regular people, living middle class lives. You are creating myths that keep people feeling insecure and powerless about finance, when what you should be doing is educating them. In the end, this was a crisis not only born of greed, but also of ignorance.
"The problem at the banks were not the auditors, the banks books were in accordance
with GAAP. Correct books however, does not mean a company is well run. "
Your own words.
You are digging further the grave of auditor's morality here. Basically
you are saying that it doesn't matter if a listed company is badly run as long as books are
in compliance with GAAP, it is not the job of the auditors to raise the alarm but to bill
their hours and run away...
Auditors are not engaged to opine on whether or not a company is badly run, only regarding compliance with GAAP. Ethical standards prevent us from coming out to the general public that we think management is incompetent - doing so would likely open a firm up to litigation for any "damages" done to said company's reputation and business. Usually, auditors provide the Board of Directors and management with a letter pointing out any recommendations for improvement or material weaknesses within the company's control structure, but again ethical standards prevent publishing this information for anyone other than management and the Board. I don't consider it amoral that auditors work within the constraints placed upon them.
Audit procedures are focused on the proper accounting of a company's transactions. Standards have changed in recent years to require increased analysis of such qualitative factors as the "tone at the top," but come nowhere near what is needed for auditors to reliably analyze business practices. I would agree that an audit could do more, but that would not only require a change to the auditing standards that direct the way accounting firms do business, but also accounting standards to which auditors attest. Therefore, criticism should perhaps be given to the FASB as well for not requiring disclosure of management's competence or other matters that may have proved more useful in preparing for or preventing this situation.
Ms. McKenna ... I recall when Arthur Anderson was eliminated due to its accounting practices in the wake of the ENRON collapse I had a discussion about the events with one of my colleagues who invited me into his office. In a hushed voice he told me that his brother worked for one of the other members of the Big Five Accounting Firms and as he understood it the accounting policies that Arthur Anderson was put out of business for engaging in were standard operating procedures throughout the industry.
In the wake of Arthur Anderson's demise I have no idea if the Accounting Industry was forced to revise its processes ... but I can guess,
At some point I'm sure we will discover if the remaining four Accounting Firms learned the lessons of ENRON and reformed, and that is a scary thought.
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@FogBelter
You only have to read any of the PCAOB reports on the audit firms engagement "quality" to know that they have not been doing their job, however anyone would like to narrowly define it. http://ret
Nothing changed for the firms after Enron, except that they are now regulated by a government body rather than self-regulated. But a lot of good that did. As a recent post on my blog states, the PCAOB is a revolving door. It seems there was no rule established to prevent regulators there from returning to their firms. So much for their objectivity and independence when they were developing and enforcing standards at PCOAB.
fm
This article is fantastic right on the subject !
You know that auditing is done in slices and it is always the kids who are performing the hands on. The bigger picture is never perceived by the kids and the older maturity level is involved in the schmoozalo part of the business.
Commercial real estate, for example, with valuations that use cap-rates of 4.5% is a prediction for future problems, but in the cruze-mode of 2003 this was "rationalized" as part of lower interest rates (that anyone with experience knows were temporary). And... of course, a large part of the problem that eluded everyone was the predominance of negative real interest rates. And whose responsibility was it to question Sir Allen Greenspan? (If there is no speed limit, how can anyone be speeding?)
I think it would be fine if "bean counters" reverted back to being bean counters. As I can tell by your resume, you know well the problem when bean counters become consultants of bean quality.
Everybody want to be "creative" these days
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