Capital Ideas Blog

Do audit firms care about reputation?

By Francine McKenna
July 10, 2013

From: Blog

Today’s global audit firm isn’t worried at all, in my opinion, about its reputation—one of the most important characteristics of a true professional services firm.

On June 18, the New York Department of Financial Services, that state’s banking regulator, announced a fine of $10 million and a one-year ban for global audit firm Deloitte’s Financial Advisory Services practice. Deloitte FAS LLP, the consulting firm sanctioned by the NY DFS, is also the one responsible for the OCC/Fed mandated foreclosure review at JP Morgan.

That’s not quite the same audit firm, according to Deloitte, as the Chinese version called Deloitte Touche Tohmatsu CPA Ltd. The Chinese Deloitte firm has the most “occurrences of fraud” among its US-listed Chinese company clients and it’s the one fighting the SEC and the PCAOB, the US auditing regulator, about access to its workpapers related to these audits.

Deloitte Consulting, the consulting firm, not to be confused with Deloitte FAS LLP, is the one that was sued for negligence by the Los Angeles School District, Marin County CA, and Levi Strauss, amongst others, for systems implementation and technology engagements. There’s also Deloitte’s tax advisory firm and another consulting practice focused on supporting sovereign governments all over the world that occasionally also gets into trouble.

You may be reasonably confused about all of Deloitte’s activities. Deloitte, one of the Big Four remaining global audit firms after the demise of Arthur Andersen in 2001, is the only remaining large firm that didn’t sell its consulting arm at the time. Deloitte’s consulting business has been growing like gangbusters ever since. There’s Deloitte LLP US, the audit firm that’s responsible for the financial statement opinion for the entire Federal Reserve Bank system, financial services firms like Blackstone, BlackRock, and Morgan Stanley and crisis survivors such as General Motors. Deloitte LLP US also audited failed, forcibly acquired firms like Bear Stearns, Washington Mutual and Merrill Lynch as well as criminally fraudulent failures such as the mortgage originator Taylor Bean & Whitaker.

Deloitte is the best example of a new-style, post- Sarbanes-Oxley Big Four audit firm, one that looks more and more like any other multinational corporation hiding behind myriad separate legal entities than a global professional services partnership providing “seamless” service delivery.

When the NY State DFS first made its allegations against Deloitte last year, I said that  “reputation risk” is an oxymoron. Bankers, and the audit firms that support them, aren’t worried about reputation because no one that matters to them is. Auditors play Switzerland when providing tax, audit, consulting, risk and compliance, and valuation services to banks and the regulators who regulate them. The audit firms, and their clients, are repeatedly the subject of settlements, consent decrees, non-prosecution agreements, cease and desist orders and the rest of the regulator arsenal and they all stay in business for the sake of jobs, growth and financial system stability.

"Audit Quality and Auditor Reputation: Evidence from Japan," a research paper by Douglas Skinner of Chicago Booth and Suraj Srinivasan of Harvard explores the reputation effect on auditors when failure, fraud and client litigation are their constant companion. The authors’ initial premise—that high-quality auditing is a central component of well-functioning capital markets—is arguable. The “relevance and usefulness” of the audit opinion, according to investor feedback to the PCAOB, could be vastly improved. The current debate over changes to the auditors’ report suggests today’s audit opinion is a poor example of audit quality if that’s defined as avoiding too many audit failures.

Let’s assume investors would still pay millions for the auditor’s opinion without the legal mandate for an independent audit. Skinner and Srinivasan tell us accounting literature focuses on two principal forces motivating an auditor to deliver a quality audit: the threat of litigation/cost of liability insurance and the desire to maintain a professional reputation. If an auditor can be found legally liable for an audit failure, he/she has an incentive to deliver a high-quality audit to avoid the cost of litigation.

Skinner and Srinivasan discuss the case of PwC’s former Japanese firm, ChuoAoyama, to explore the value of reputation to an audit firm. In May 2006, Japanese regulators suspended the operations of ChuoAoyama for two months for its role in a major accounting fraud at Kanebo. PwC took immediate actions to remediate the issues including sending senior personnel such as the Global Chairman of the firm to mediate with regulators and personally address audit quality fixes. PwC set up a new, smaller Japanese affiliate, PwC Aarata, supposedly a higher-quality audit firm but built with the former partners of ChuoAoyama that PwC considered untainted. When another major fraud was revealed after the suspension was lifted, PwC finally shut down the old firm, now called Misuzu, too. PwC is now a distant fourth place among the firms in the Japanese audit market.

“These actions make it clear that PwC viewed the audit-quality issues at ChuoAoyama as potentially damaging to its international reputation, and support our view that an auditor’s reputation for quality is of first-order importance,” according to Skinner and Srinivasan. Auditors have “reputational incentives to avoid audit failures because audit quality is valuable to clients and so priced in the market for audit services…clients defect to other auditors when an audit firm’s reputation for quality deteriorates.”

But do they really? The authors admit most prior literature “finds mixed support, at best, for the importance of auditor reputation as a driver of audit quality.”

There’s an old expression, “Better the devil you know than the devil you don't know.” The US federal government, for one, seems unaffected by auditor reputation when making audit firm choices. The audit regulator, the PCAOB, published the private audit quality reports for three of the four largest firms because of their unwillingness to correct significant weaknesses in audit quality within the required timeframe.

KPMG was not debarred from federal contracts after its guilty plea and record fine for tax shelter crimes in 2005 that almost resulted in a criminal indictment that would have been an Andersen-like death penalty. The US Treasury and near failure and one-time government majority-owned Citigroup still use KPMG as their auditor. AIG executives beholden to federal government owners rehired long-time auditor PwC again and again even though PwC has been sued by, and settled with, AIG shareholders more than once and missed AIG’s risk run up until that company was taken over by the government, too. The US Treasury and New York Federal Reserve hired Ernst & Young in 2008 to help manage the TARP program even after EY’s role as auditor of failed Lehman Brothers was criticized by the Lehman Bankruptcy Examiner and the New York Attorney General sued EY for fraud in the case. The federal government hasn’t debarred Deloitte as as one of its largest government contractors, in particular for the defense department, in spite of all the failures the firm has presided over and the ban by the New York state authorities for Deloitte’s “misconduct, violations of law, and lack of autonomy during its consulting work” at Standard Chartered Bank on those anti-money laundering (AML) issues. The Federal Reserve still uses Deloitte as its auditor.

If the US government and many large foreign ones are not bothered by the declining reputations of the audit firms, why should the audit firms and their industry clients care?