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- Watchdog groups and whistleblowers are worried that poor-quality auditing of public companies could lead to another financial crisis.
- Research by the Project On Government Oversight indicates that the largest accounting firms are doing a sub-par job of auditing public companies and the regulatory agency that is supposed to oversee their work has largely given them a pass for their shoddy work.
- According to that regulatory agency — the Public Company Accounting Oversight Board — between 20% and 50% of audits it sampled shouldn’t have been relied on, because they had critical flaws.
- Despite the high failure rates and problems, the fines the PCAOB has levied against the Big Four accounting firms are few in number and small in total amounts.
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The last three financial crises — the Great Recession a decade ago, the dot-com bust at the turn of the Millennium, and the savings-and-loan crisis thirty years ago — were marked and arguably sparked by significant accounting irregularities and fraud.
A group of experts are worried now that a new wave of accounting problems are going undetected and could lead to yet another wide-scale financial catastrophe. The four largest accounting firms, which dominate the industry, are doing a poor job of auditing public companies. Worse, the regulatory body in charge of overseeing the accounting firms has largely given them a free pass, taking few actions against them and issuing minimal fines.
“When the auditors aren’t doing their jobs or aren’t doing what they’re supposed to be doing, we’ve seen the harm that can come,” said Tim Stretton, a policy analyst at the Project On Government Oversight, or POGO, an independent, nonpartisan watchdog group. “We don’t want another economic crisis on our hands.”
Last week, POGO, in conjunction with other auditing watchdogs and whistleblowers, sent a letter to the leaders of the House Financial Services Committee and its Investor Protection, Entrepreneurship, and Capital Markets subcommittee encouraging them to hold a hearing on what the watchdogs described as the failures of the Big Four and the regulatory body. POGO and its allies warned about the risks of those failures to the financial markets and the broader economy.
“This country cannot afford another economic crisis, and the Financial Services Committee has a responsibility and duty to do everything in its power to ensure that regulators are adequately policing auditors and doing their jobs,” POGO and the other groups and individuals wrote in their letter.
Representatives of the Financial Services Committee did not respond to requests for comment.
The many audit problems have led to few fines
Since September, POGO has published a series of investigative reports highlighting problems in the accounting industry and particularly with the Public Company Accounting Oversight Board, the quasi-governmental entity charged by Congress with regulating auditors. The reports paint a damning picture of the PCAOB and the industry.
Part of the PCAOB’s job is to assess the quality of the audits performed by accounting firms, particularly the Big Four — Ernst & Young, KPMG, Deloitte & Touche, and PricewaterhouseCoopers. Those four firms audit 99% of the companies in the S&P 500, according to Audit Analytics, attesting to the accuracy of their financial statements and the adequacy of their internal controls, the formal system of checks and balances companies are required to have in place to prevent fraud.
Every year, the PCAOB examines a collection of audits performed by each of the major accounting firms, assessing whether they were done in accordance with accounting rules and standards. The point of the inspections is not necessarily to search for accounting fraud or mistakes. Instead, it’s to determine whether the audit process was reliable — whether it was done in such a way that the auditors could have reasonably found fraud or mistakes if they were there.
Since its inception in 2003, the PCAOB has identified 808 instances when an audit performed by a Big Four firm was so shoddy that either a company’s financial statements shouldn’t be relied on or its system of internal controls should be trusted, according to POGO’s research. Yet, by contrast, the agency has only brought 18 enforcement actions involving just 21 audits over that same time period, according to POGO.
The PCAOB could have assessed the Big Four firms fines totaling at least $1.6 billion — and possibly several times that — for those audit failures. Instead, it’s assessed just $6.5 million in fines total against the accounting giants over its lifetime.
PCAOB representatives did not respond to requests for comment from Business Insider. A representative of the Securities and Exchange Commission, which oversees the PCAOB and also came under criticism in the letter, declined to comment.
The PCAOB has found high failure rates
But defenders of the agency have told POGO that it shouldn’t be judged on the number or amount of fines it has assessed. Instead, the agency’s goal is to improve audit quality, and rather than being heavy-handed with fines to achieve that goal, it often uses a lighter touch.
Those efforts are working, PCAOB Bill Duhnke argued in a hearing before the House Financial Services Committee last month. Financial restatements — which typically are the result of mistaken accounting or flawed audits — are at an 18-year-low. And the kinds of problems the PCAOB is finding in its audit inspections are typically less severe than it found when it first began operations, Duhnke said.
If people were to examine the agency’s records and inspection reports, “what they’ll see is gradual improvement,” he said.
But POGO’s research indicates that the PCAOB’s light hand has actually done little to get audit quality up to respectable levels. Instead, many of the audits performed by the Big Four still have significant problems.
In the latest round of audit inspections performed by the PCAOB, the four major accounting firms had failure rates ranging from 20% for Deloitte to 50% for KPMG, POGO found. In other words, of the audits the agency inspected, at least one in five and, in the case of KPMG, up to every other one, shouldn’t have been relied on.
For POGO’s Stretton, the audit failure rates say a lot more about the state of audit quality than they do the number of restatements. Indeed, it’s possible that the reason why restatements have declined so much is that the accounting firms aren’t catching mistakes because they’re doing such a bad job of auditing companies, he said.
“If you ask me, between 20 to 50 percent failure rate is not really that good,” Stretton said. “And I think it’s troubling if the PCAOB thinks that that’s an acceptable rate of compliance.”
Here is the letter the watchdog groups sent to the House Financial Services committee:
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