Deloitte, KPMG, PricewaterhouseCoopers (PwC), and Ernst Young (EY), the so-called “Big Four,” dominate the global auditing, accounting and corporate consulting industry. Operating through global professional network services, the companies within these four networks employ hundreds of thousands of employees around the world and bring in tens of billions in revenue each year.
Investors depend on the Big Four to provide accurate accounting services and to provide independent evaluations and examinations of financial statements. However, evidence suggests that these services might not be as reliable as the firms claim. In the United Kingdom, the Competition and Markets Authority found that, in 2019, all four had failed to meet audit quality targets. Data from the Public Company Accounting Oversight Board, the U.S. auditing regulator, suggests that auditing firms fail at an alarmingly high rate, with 20% of the Deloitte audits examined deemed inadequate, along with 23.6% at PwC, 27.3% at EY, and 50% at KPMG. Research also shows that multinational companies that hire the Big Four make greater use of tax havens, and that, when a company takes on a Big Four firm, their tax practices become more aggressive.
As part of their consulting services, the Big Four publish frequent reports on the likelihood and risks of corporate fraud. These reports frequently reference the fraud triangle, a model that suggests that fraud is most likely to occur when the following three factors are present: (1) motivation (incentives or pressure), (2) opportunity, and (3) the pre-existing ability to rationalize fraud. Through the lens of the Big Four’s own recommended fraud tool, the oversight of corporate financial reporting appears to be concentrated in firms that are themselves at a high risk of fraud.
Motivation
After mergers in the 1980s and 1990s, the Big Eight became the Big Five and, after Arthur Andersen’s collapse, the Big Four. Today, these four groups audit 97% of U.S. companies. With an effective oligopoly, these groups have little incentive to stay competitive by demonstrating effective auditing abilities.
Rather than being incentivized to find flaws, market incentives encourage auditors to ignore them. In 2019, a study of 13 years of data from 358 audit firms (about half of which are part of the Big Four), found that auditors saw a 2.2% drop in client growth for each flaw highlighted and 6.1 percent lower fee growth over the next year. The Big Four also make as much as three times the amount from consulting fees than they do from auditing fees, providing additional disincentive to anger potential consulting clients by pointing out internal control weaknesses.
A lucrative business model centered around meeting clients’ needs can put pressure on even otherwise honest employees to ignore or even to help facilitate financial fraud. Financial fraud expert John Coffee has pointed out that, “although auditors serve investors, they are hired by management.” In other words, it’s difficult to get auditors to catch fraud that their salary depends on them not catching.
Instead of competing to produce greater audit quality, these groups have arguably engaged in a race to the bottom, competing for clients over cost and a willingness to look the other way. The need to maintain clients manifests in pressure on senior partners to keep business through greater accommodation. According to accounting ethics expert John Edward Ketz, partners at auditing firms are “evaluated positively on the business they keep and the business they bring in, but evaluated negatively on lost clients. In such a setting, there is pressure – even if only subconsciously – for the partners to accept a little misbehavior here or there to keep or to win the business.” A revolving door between auditing firms and the large clients they audit provides additional disincentive not to find errors that might cause problems later on.
When firms are caught ignoring red flags, the resulting fines are often too small to disincentive future violations. For example, the $536,000 fine Deloitte paid in 2019 in Malaysia for its role in the 1MDB scandal was less than .001% of the company’s 2019 revenue. In other cases, the Big Four are relied on by governments to advise on post-crisis financial regulation or investigations, allowing them to profit off the scandals that they or their competitors fail to catch. While these companies experienced minor setbacks for their failure to catch the 2008 financial crisis, financial journalist Richard Brooks has pointed out that the fees they made from advising on financial reforms in the aftermath far exceeded their losses.
On the accounting side, these companies have little disincentive to prevent companies from engaging in aggressive tax practices and a serious financial incentive to encourage it. Enabling companies in profit-shifting is an incredibly lucrative business, with an estimated $500 billion in profits shielded from taxes each year. When companies are challenged on tax practices, deferred prosecution agreements and small settlements in some cases provide weak incentives for companies to change their behavior.
Opportunity
With just four companies remaining, the Big Four firms are not just too big to fail; they have also succeeded in arguing that they are also now “too few to fail.” Since Arthur Andersen’s collapse after the Enron scandal, these companies have only grown larger, providing support for the argument that any serious penalties against these companies would only lead to further concentration.
Due to their size and dominance in the industry, the Big Four often able to maintain close relationships with regulators around the world, and revolving doors between the Big Four and regulators can disincentivize strong oversight and penalties. According to Brook Masters of the Financial Times, in the United States the “[t]he Big Four are so dominant that today’s regulator is not just a potential future industry peer, but literally tomorrow’s co-worker or boss.” The Big Four also are frequently called on around the world to advise on tax policy, allowing them to play a role in writing the rules they will later advise clients on how to follow, as well as creating a dependency on their expertise and cost-saving “donations” of staff time to underfunded regulators.
In the U.S., the Public Company Accounting Oversight Board (PCAOB) is charged with overseeing the auditing industry, but enforcement actions are rare. A report from the Project On Government Oversight studied 16 years’ worth of the PCAOB inspection reports on the U.S. arms of the Big Four, finding that the board had cited 808 instances in which the PCAOB found that firms had issued defective audits. However, the PCAOB only brought 18 enforcement cases against these firms. The report also found that, during the 16-year period, the company with the highest percentage of defective audits, KPMG, had never been fined once.
On the tax side, a lack of investigations into aggressive tax practices often allows corporate strategies to go unchallenged, providing opportunities for the Big Four to advise increasingly risky strategies with few consequences. In the United States, according to the Institute on Taxation and Economic Policy, an underfunded Internal Revenue Service has a weak ability to investigate even the most ludicrous corporate tax schemes, ensuring that strategies recommended by the Big Four are likely to go unquestioned.
Rationalization
Employee attitudes towards fraud are often difficult to reveal. However, high-level cheating scandals, including company-wide strategies for cheating on ethics and integrity tests, suggest a strong ability to rationalize cheating and deception. More importantly, the Big Four have a well-established, extensive track record of involvement in almost every type of financial fraud.
Even with weak accountability and oversight, data from Violation Tracker shows that in the last twenty years, these four firms have committed at least 57 financial offenses in the last twenty years. Several other high-profile scandals provide a picture of the influence these firms have in facilitating or failing to catch tax evasion, money laundering, and enormous corporate fraud.
Luanda Leaks, an investigation by the International Consortium for Investigative Journalists (ICIJ) and 36 media partners, highlighted the role of the Big Four in failing to catch both money laundering red flags and shifting profits. Luanda Leaks shows that, over several decades, the Big Four firms helped Isabel dos Santos build an empire of four hundred companies across forty countries to siphon billions out of Angola. The investigation details how the Big Four firms failed to file reports about suspected money laundering and made millions advising dos Santos, even after most banks cut ties.
While egregious, this conduct is likely not isolated; in 2018, the Financial Action Task Force examined 106 cases of money laundering and tax evasion and found professional intermediaries played a key role in the majority of the cases. KPGM previously pled guilty in 2005 to helping wealthy clients avoid USD2.5 billion in taxes through fraudulent schemes, while Deloitte settled charges in Malaysia that it failed to alert regulators to money laundering in the massive 1MDB scandal. In 2014, whistleblowers Antoine Deltour and Raphael Halet revealed a similar, albeit legal, scheme by PwC. In this scheme, PwC set up tax rulings in Luxembourg that allowed hundreds of multinational companies to slash their corporate taxes.
The Big Four have also consistently signed off on financial statements of companies that collapsed not long after. While Arthur Andersen’s role in Enron’s collapse is infamous, similar stories continue to spark scandals today. In the U.K., the 2018 collapse of the corporate giant Carillion implicated all four auditing companies, sparking a series of investigations into their conflicts of interest and violations related to KPMG’s audit of Carillion. In December 2020, German regulators opened an investigation into EY auditors for their role in signing off on three years of questionable financial statements for Wirecard. WireCard, a payment processor, filed for bankruptcy in 2020 after admitting that 1.9 billion euros were missing or nonexistent.
Intersection between Auditing and Climate Change
In addition to the existing threats to investors and taxpayers, poor auditing and aggressive accounting practices could also damage the climate. As climate-related financial risks grow, auditing and accounting companies unable or unwilling to spot new risks could protect the industries driving climate change – like fossil fuels and industrial logging – from financial consequences and leave investors in the dark about climate and sustainability risks.
Auditors have particularly limited capacity in relation to the fossil fuel industry, the key driver of climate change. Fossil fuel company valuations are linked to the value of proven reserves. The technical and complex nature of reserve estimates makes it difficult for auditors inexperienced in reservoir engineering to properly examine the accuracy of company reports. Without sufficient technical qualifications, auditors are unable to question assumptions that drive valuations.
The industry’s track record suggests it may not be able to catch even blatant frauds in the oil and gas industry. In 2017, auditing company KPMG paid USD$6.2 million to settle allegations that it failed to notice that Miller Energy invented more than USD$400 million dollars in nonexistent oil and gas assets, allowing a penny stock company to transform itself into an exchange-listed energy company.
As the face the energy transition, oil and gas companies could respond to financial pressure by inflating their reserves or failing to write-down assets affected by new climate-related regulations. Without rigorous oversight from external auditors, these companies could potentially hiding material climate impacts for years.
With growing concern from investors about environmental risks, auditors have also increasingly taken on the role of providing sustainability assurance reports, ensuring the reliability of non-financial information about sustainability risks. However, while assurance reports are supposed to provide investors with greater confidence, these reports may be no more reliable than the financial audits.
By giving investors false confidence through misleading assurance reports, the Big Four could provide false cover for corporate complicity in deforestation.
In October 2020, environmental groups accused APRIL, one of the world’s largest pulp and paper producers, of violating its own deforestation policy by sourcing wood from a company clearing rainforest in Indonesia. The report detailed how APRIL had previously sought to reassure stakeholders by commissioning KPMG to produce limited assurance reports on deforestation. Yet, none of KPMG’s reports had noted the deforestation that the environmental groups had identified using only the concession boundary map and publicly available satellite images, raising serious concerns about the effectiveness of this type of assurance reporting.
How Auditing and Accounting Whistleblowers Can Report Fraud
Employees in the auditing and accounting industry face serious challenges to raising the alarm about financial fraud by clients or by their own firms. Investigations in the aftermath of the Enron scandal found that retaliation against employees at Arthur Andersen prevented auditors from providing accurate audits. After the passage of the Sarbanes-Oxley Act, spurred in part by Enron’s demise, the consulting arms of the Big Four advised on the importance of maintaining proper whistleblower channels. However, allegations from former employees suggest that the Big Four do not follow the advice they publicly espouse, and the threat of career-ending retaliation still prevents whistleblowers from successfully blowing the whistle internally.
Thankfully, U.S. whistleblower laws provide strong external channels for whistleblowers to report fraud to U.S. law enforcement. The Dodd-Frank Act allows whistleblowers to confidentially report information about securities fraud. Whistleblowers do not need to be U.S. citizens, and the company does not need to be headquartered in the United States. Whistleblowers who provide original information to the Securities and Exchange Commission (SEC) that leads to a successful prosecution can receive between 10% and 30% of monetary sanctions that exceed USD$1 million.
While the SEC generally excludes external auditors and accountants from becoming whistleblowers, there are several key exceptions. External auditors and accountants can become whistleblowers if:
- They have a reasonable basis to believe that disclosure of the information to the SEC concerning material violations is necessary to prevent the relevant entity from engaging in conduct that is likely to cause substantial injury to the financial interest or property of the entity or investors
- They have a reasonable basis to believe that the relevant entity is engaging in conduct that will impede an investigation of misconduct related to material violations.
- They have informed a superior in their firm about improper or illegal activity by the client and the firm has failed to report this to the SEC.
The Internal Revenue Service (IRS) also allows whistleblowers to report tax violations. Any individual who is able to obtain credible information of a major tax fraud can file an IRS whistleblower claim, including outside contractors. Under the IRS whistleblower program, if there is a successful prosecution that meets the financial qualifications (over $2 million in taxes, penalties, and interest OR gross income over $200,000), the whistleblower will be entitled to an award of between 15 and 30 percent of the total amount collected by the government.
Using these laws, whistleblowers can play an essential role in detecting and prosecuting financial fraud and corruption. Whistleblowers like Bradley Birkenfeld and Antoine Deltour have shown the power that whistleblowers can have in revealing fraudulent global financial schemes. Thanks to powerful U.S. laws, auditors and accountants around the world are well-suited to report fraud, while protecting their identity and qualifying for a financial reward.
