Why it’s getting harder to trust the auditors

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As Dimitri Lascaris sat in the conference room, he could not believe his ears.

It was February 2014, and the Canadian lawyer was sequestered on the fifth floor of World-Wide House, a stout aqua-blue glass office tower overlooking Hong Kong's downtown. Lascaris was there to interrogate some of the auditors who once scrutinized the books of Sino-Forest Corp., a Mississauga, Ontario, timber company that had cratered spectacularly in 2011 after being accused of operating as a Ponzi scheme. The collapse wiped out more than $6 billion of investors' value.

Now 54, Lascaris – a barrel-chested litigator with a gleaming bald head and the physique of a wrestler – was running the securities class action team at Siskinds LLP, a London, Ontario, law firm. He was in China conducting cross-examinations for a shareholders' lawsuit seeking more than $1 billion in damages against Sino-Forest and its auditors, Ernst & Young LLP (EY) and BDO Ltd. Although headquartered in Canada, Sino-Forest’s timber assets were mainly in China.

Lascaris’s line of questioning was straightforward: How had the auditors – for 17 years, no less – managed to miss the fact that Sino-Forest did not actually have title to most of the forests it claimed to own?

“How could it have been appropriate to withhold from the public the fact that there were virtually no plantation rights certificates?” Lascaris asked Wong Chi Wai, an auditor who worked at BDO’s Hong Kong firm, during one session.

“We [do] not provide opinion as to whether Sino has ownership in the timber holding,” replied Wong. “Even if Sino has no ownership, it doesn’t mean that Sino cannot recognize the timber holding as an asset in the financial statements.”

Wong continued, using a rather tortured analogy of someone leasing a photocopier. “If we believe that the company should have owned economic benefit arising from using the [photocopier], then the asset can be recognized as an asset in the financial statements.”

After hearing a string of such impenetrable and illogical explanations, Lascaris flew back to Canada a happy man. “It was like shooting fish in a barrel,” he relates. “I had so many weapons to employ against these guys.” Two former partners at EY sat on Sino-Forest’s board, along with one other chartered accountant and a former senior manager at BDO who’d joined Sino-Forest’s management team and who had been charged with fraud by the Ontario Securities Commission (OSC) in 2012. Within a year of Lascaris’s trip to Hong Kong, EY and BDO had shelled out a total of $126 million to settle the suit - one of the largest payouts to investors in Canadian history. “They just gave up,” chortles Lascaris. EY also paid an $8-million fine to the OSC. BDO Canada says it did not participate in the audit of Sino-Forest; it was handled by BDO Hong Kong, a separate firm.

In a written response to questions from Report on Business magazine, EY says it settled to “put these matters behind us” and that neither settlement involved any admission that the firm or its employees failed to comply with professional standards. EY also notes the OSC did not suggest any of its employees knew about the fraud. The commission did, however, find four senior Sino-Forest executives guilty of fraud last year.

Siskinds often sues auditors. And why not? Since 2015, Canadian auditing firms have collectively shelled out more than half a billion dollars in settlements and judgments for failing to warn investors about various frauds and accounting irregularities.

Which is no minor detail, given how difficult our laws make it for investors to sue auditors. Currently, Siskinds is part of a group of law firms suing PricewaterhouseCoopers LLP (PwC) over its failure to uncover an alleged fraud at Valeant Pharmaceuticals International Inc., once Canada’s largest drug company and the hottest stock on the TSX.

The suit is seeking billions in damages.

Such legal claims can take decades to work their way through the courts, but the recent string of payouts doesn’t help the reputations of the Big Four auditing firms – KPMG, EY, PwC and Deloitte – which are facing a perfect storm of scandal and condemnation on several fronts. In the U.K., both Deloitte and KPMG failed to sound the alarm about the pending collapse of Carillion PLC, Britain’s second-largest construction company. British authorities are now threatening to break up the Big Four or force them to sell off their non-auditing divisions. In South Africa, KPMG alone has lost 20 large clients since the beginning of last year due to its role in a major corporate scandal. Earlier this year, the International Forum of Independent Audit Regulators released a global survey from over 33 jurisdictions that found 40% of audits had at least one deficiency.

The root of the crisis stems from growing concern over whether the Big Four can be trusted to perform basic rigorous and sound audits. And the main reason is their perceived inherent conflict of interest – they’re paid by the very organizations they’re supposed to be overseeing. Without a truly objective third party signing off on the financial statements produced by large corporations, many investors, shareholders and analysts are beginning to feel they can’t trust the numbers.

And it’s a feeling that intensifies every time there’s a scandal like Sino-Forest – which Lascaris calls “a raging indictment of the auditing profession.”

Some experts in the field are starting to wonder about the role of auditors in capital markets and, more specifically, how audits are performed.

Questions that would have seemed heretical just a few years ago are now being asked: Do auditors really need to work directly for the firms they’re auditing? Are modern accounting standards being misused to produce misleading financial statements? The winds of change are weak in Canada right now, but they’re growing stronger in other countries, as shareholders grapple with a nagging question that just won’t go away: “What function do auditors serve when they are not able to find material misrepresentation?” asks Lascaris.

“What function do they serve?”

I’m on the phone with Prem Sikka, who works at the University of Sheffield in the U.K. as a professor of accounting. He’s one of the world’s leading critics of the profession. “To be honest, I don’t think there was ever a ‘golden age,'” he says, "but I think it has crossed a particular threshold. Increasingly we have this culture where people’s performances are evaluated not in terms of ‘Have you done a good job?’ [but] ‘Have you kept the client…and have you managed to sell consultancy services?’ " One reason Sikka doesn’t trust the industry is because it’s an oligopoly. Combined, the Big Four audit 490 of the S&P 500 companies, 98 of the U.K.'s top 100 corporations and an estimated 80% of Japan’s listed firms. In turn, the Big Four have become huge conglomerates themselves – with total combined revenues of $134 billion (U.S.) in 2017, employing 945,000 people worldwide.

More worrying, it’s an oligopoly that doesn’t seem to learn from its mistakes. In 2002, Arthur Andersen went bust after it was accused of helping Enron hide losses (Arthur Andersen’s parent firm, Andersen Worldwide, also had a consultancy practice, which was split off in 2000 and renamed Accenture. It is still operating.)

“I think there is a credibility issue, and I think it has been a credibility issue for 20 years now,” says a senior partner at a Canadian accounting firm who spoke on condition of anonymity.

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Meanwhile, the outrages keep piling up. In recent years, there have been several major scandals in the U.K.: Auditors failed to alert investors when senior executives fraudulently inflated profits by $331 million (U.S.) at Tesco, the country's largest supermarket chain. Then there was the $6.6-million (U.S.) fine PwC paid for its role in the collapse of accounting firm RSM Tenon.

Finally, there was the biggest scandal of them all, when auditors failed to sound the alarm about the pending collapse of Carillion, which unexpectedly went insolvent this past January, putting tens of thousands of jobs in jeopardy. It was a particularly damaging incident, since KPMG had signed off on numbers that gave a reassuring view of Carillion, suggesting it would survive at least three more years.

In a report published in May, a joint U.K. parliamentary inquiry recommended a possible breakup of the Big Four. British MP Frank Field, head of one of the committees investigating the collapse, described Carillion’s auditors as “companies feasting on what was soon to become a carcass.”

When Deloitte and KPMG appeared before a British parliamentary committee in February, they were openly mocked by MPs: “I wouldn’t hire you to do an audit of the contents of my fridge," one said, "because when I read it, I wouldn’t actually know what is in my fridge or not.”

Here in Canada, we’ve had our own share of confidence-shaking disasters, including those at Sino-Forest, Poseidon Concepts, Nortel, Livent, Valeant, Mount Real, Castor Holdings and Philip Services. Investor losses in these cases have added up to tens of billions – which arguably could have been avoided if auditors had done their jobs properly.

Livent Inc., the entertainment company set up by Garth Drabinsky and Myron Gottlieb, collapsed in 1998, losing $400 million of investors' money. The pair was eventually charged with fraud and went to prison.

One judge noted that Livent was “rife with fraud, which burrowed deep into the operation.”

When Livent’s auditor, Deloitte, was sued, expert testimony at the 2013 trial suggested the company should have caught Livent’s fraud at least two years before it was uncovered. The trial also revealed that a former partner who once oversaw Livent’s audits went on to work for the theatre company – and kept quiet about the fraud for a full year. At one point, Gottlieb demanded Deloitte’s audit team be replaced because it wouldn’t inflate second-quarter numbers, and Deloitte supplied a new team. In the end, the judge found that Deloitte knew Drabinsky and Gottlieb were using questionable numbers to raise money from investors and ordered it to pay a penalty of nearly $85 million. (Last year, the Supreme Court of Canada reduced the penalty to $40.5 million.)

In a written response to our questions, Deloitte noted it’s been more than two decades since Livent was a client and that “audit quality has been significantly enhanced with standards and regulation that didn’t exist 20 years ago.” The firm adds that “both the profession and Deloitte have evolved significantly since the late 1990s.”

Meanwhile, Sino-Forest, which raised $2.7 billion on the capital markets before it was exposed in 2011, claimed to have acquired timber it probably didn’t own and recorded sales it likely had not made. The company even paid bribes to Chinese forestry bureau officials. None of these facts were reported in financial statements. Lascaris notes that the auditors “made a lot of money and had no financial incentive to inquire.”

Compounding the scandal was the fact that many of Sino-Forest’s senior directors and executives were auditors themselves – former partners of EY and BDO. Which is just one of the reasons Sikka feels let down. “I think the whole industry is kind of rotten,” he says.

To find out how things got this bad, I went to meet Elliott Jacobson, a retired auditor with a long and storied career. We sit on the sun-dappled patio of a hipster café in Toronto’s Distillery District. Tanned and dapper in a sky-blue shirt, the 72-year-old is enjoying his retirement. Jacobson began working as an auditor in 1978 and felt it was a noble calling. “I was a happy warrior,” he tells me. Jacobson’s colleagues nicknamed him ‘Columbo' due to his propensity for asking so many questions.

He worked at Arthur Andersen, and then from 1989 to 2008, Jacobson ran the public company audit practice at Mintz & Partners LLP, a midsized Toronto firm, before Deloitte gobbled it up. Jacobson retired in 2010. By that time, he had grown disappointed by his occupation. Says he: “Maybe the smartest bears in the woods are not doing audits.”

Jacobson believes the calamities befalling the auditing profession are largely caused by one elephant-in-the-room reality: the inherent conflict of interest auditors face by being paid by the very people they’re supposed to be scrutinizing. After all, auditors don’t want to lose clients by being too difficult. Or, as Jacobson notes, “If you’re a partner and you have one big client, and you lose that client, then you don’t have a job. No one thanks you for losing a client.”

It’s no mystery why the Big Four don’t want to alienate clients: The sums at play are enormous. Nortel Networks Corp. was paying its auditors almost $20 million a year at one point, and Enron was on track to pay $100 million (U.S.) a year to Arthur Andersen. “So the incentives of the auditors are to essentially please major clients, who contribute a major portion of their revenue,” says Joshua Ronen, a professor of accounting at New York University. “In other words, the money speaks.”

A former EY employee recalls a colleague telling him there was an error in a major file that affected reported earnings per share. “The partners essentially decided to just let it go, because it was one of their very, very important clients at that time,” he says.

Part of the problem is that auditing is becoming less important to the Big Four. Originally, auditing was pretty much all they did–today, it constitutes less than one-third of their business. The big money-makers now are services such as management consulting, and providing legal and IT solutions. Richard Brooks, a British journalist and author of a recent book on the auditing profession, Bean Counters: The Triumph of the Accountants and How They Broke Capitalism, believes the large auditors have “lost sight of their core purpose.” He adds: “It’s not really any longer an accountancy profession.”

These days, audits are often seen as a “foot-in-the-door” means for the Big Four to offer other, more lucrative services to potential clients.

To that end, Deloitte, the biggest of the lot, has been on a buying binge in recent years, gobbling up legal service, digital marketing, consulting, security, IT and business intelligence firms. It has reached the point where today, “Deloitte does not consider itself an accounting firm,” says a senior member of the accounting profession. “And it hasn’t for a very long time. They consider themselves to be a technology firm….We could argue until we are blue in the face about liability and whether it’s good or bad for the profession. This argument is less important for Deloitte. Auditing is less and less a portion of their overall revenue every day. So at a certain point, they don’t care.”

Just as the famous Soviet-era writer Aleksandr Solzhenitsyn was once the lone dissident voice in Russia, Al Rosen often feels like the only critic willing to take on the Canadian auditing industry. Well into his 80s, stooped with age, Rosen is the dean of Canada’s forensic accountants. With his son Mark, he runs equity research firm Accountability Research Corp. from the eighth floor of a small office building in the heart of Toronto’s business district.

When I went to visit him one Friday afternoon, he was attired in a grey cardigan and sitting in a boardroom in his poky offices, a cluster of financial statements fanned out in front of him. The statements were from marijuana companies, and he presented them as evidence of what he considers the auditing profession’s greatest sin: the International Financial Reporting Standards (IFRS) system. “The idea of faking financial statements is not new,” he explains, “but IFRS encourages you to do it.”

IFRS is relatively new here – it replaced generally accepted accounting principles (GAAP) in Canada about seven years ago. One key difference between the two sets of rules is that IFRS allows companies to determine the fair value of their assets before those assets are realized. Under GAAP, an asset was generally valued at the original purchase price until it was sold. “You had, for years, accounting that said, when the egg hatches and I see a chicken and it survives, then I say you have an asset of one chicken,” explains Rosen. “Now they are recording stuff that they may or may not get up the road in profits. And it does nothing to control them from exaggerating two-, three- or four-fold.”

The most glaring evidence of this problem is in the cannabis sector. Four of the biggest marijuana companies listed on the TSX collectively reported less than $190 million in revenue in the last 12 months. Yet the combined market value of these companies is a whopping $28 billion – despite the fact that Statistics Canada says that last year, Canadians spent only $5.7 billion on cannabis.

IFRS requires marijuana companies to determine what the value of their crops might be at different points while their plants are still growing.

“Much of IFRS bears a close resemblance to the type of reporting that was utilized leading up to the 1929 stock market crash,” says Rosen. “Everything is speculative.”

IFRS also permits pot producers to book gross profits and gross margins based on unsold inventory. As a result, some companies are reporting gross profits and net profits far in excess of actual revenues.

Consider CanniMed Therapeutics Inc., a medical marijuana firm recently acquired by Aurora Cannabis Inc. In its 2017 annual report, the company said it had revenue of $16.7 million and a gross margin of $11.1 million. Yet, under GAAP, the gross margin could have been much less: roughly $1 million, according to its financial statements.

The gross margin under IFRS is so high because the company could claim potential earnings of $9.8 million on future crops, Rosen says.

Under IFRS, companies have more latitude in the value they assign to assets. This arbitrary manipulation of asset value can have an enormous impact on stock prices. Take Mainstreet Equity Corp., a Calgary-based outfit that manages apartment buildings. Under GAAP, Mainstreet had a net loss of more than $3 million in fiscal 2011. But when it presented the results for the same fiscal year using IFRS, it recorded a net profit of $82 million instead.

That’s partly because IFRS permitted Mainstreet’s management to increase the value of its buildings by more than $75 million, according to its financial statements. The effect on Mainstreet’s stock was dramatic – it shot up by 40% in three months.

The effect the IFRS system can have on financials doesn't seem to faze Linda Mezon, chair of the Accounting Standards Board, which is funded by the Chartered Professional Accountants of Canada (CPA Canada). She argues there's little difference between how fair value is determined under GAAP and IFRS. Companies can reasonably estimate the fair value based on the changing market while crops are still in the ground, she explains.

Mezon also notes that the wild swings in the market valuations of the licensed producers will stop when the market matures. “Because of where we are in the legalization cycle, people are trying to figure out what the recreational market will do to demand,” she says.

Given that auditing firms are hired directly by the firms they audit and supply those firms with a growing array of other lucrative consulting services, it’s not surprising there’s tremendous pressure to produce audits that make their clients happy. Most of the time, auditors play by the rules.

EY, in particular, writes that it “always will be our highest priority to serve the public interest and promote trust and confidence in financial reporting.” But the number of cases in which auditors show willful blindness or step over the line indicates this is a problem that needs to be fixed. After all, if shareholders can’t trust the numbers, the whole market system starts to fall apart.

There’s no easy solution, though, and experts around the world are divided on what to do. In the U.K., as the debate has intensified, regulatory authorities are looking at reforming the sector, suggesting that the Big Four be forced to sell off their non-auditing divisions. But David Albrecht, who spent 32 years as a professor of accounting at various American universities, says that wouldn’t solve anything. He believes the very same audit teams currently working with the companies would remain in place, and smaller audit firms would become more dependent on large corporate clients, making them less likely to raise questions. “There would be more pressure on them to be in bed with the clients,” he says. Besides, says Tom Naylor, a McGill University political economist, “They would never break up [the Big Four]. They have too much political power.”

As it turns out, though, there is a market-driven solution to the conflict of interest between auditors and their clients. It has been much discussed within academia but, so far, never implemented in the real world. The idea is to bring in regulations that force public corporations to buy a new type of insurance, one that would cover any payouts due to misrepresentations in financial statements. So if a fraud did come to light and a public company was forced to make a payment to investors as a result, the insurance would cover the costs.

Joshua Ronen, a professor of accounting at New York University, is a proponent of this model. He says the amount of insurance coverage corporations obtain, and the premiums they pay, would be disclosed. “Those corporations with higher coverage and lower premiums would distinguish themselves in the eyes of investors,” he says, and insurance carriers would welcome the new business. But they would need to properly gauge their risk - which is where the auditors come in.

The insurance carriers would appoint and pay auditors to assess their prospective clients' financial statements. Risk assessments, which would be conducted by competitive entities, including potentially the auditors themselves, would help the carrier decide on the coverage and premium.

By knowing how much (or how little) insurance coverage comes with the securities they buy, investors would be able to tell which stocks are more reliable and which corporations more trustworthy. This would also solve the conflict of interest issue, since the auditors would not be hired by the companies they audit but by the insurance company instead. “The total cost to the corporations - insurance premium, plus the reimbursement of the audit fee - would not be much different from what they currently pay in audit fees, premiums for directors' and officers' liability insurance, and litigation settlements,” Ronen explains.

It's a fascinating idea, but it's not likely to be implemented in the short term, barring government intervention. In the meantime, however, there are simple, more immediate solutions.

For starters, we could admit that IFRS has watered down the accounting rules too much and return to the GAAP system. The U.S. continues to use GAAP, and harmonizing the accounting systems across North America is not a crazy idea. “In my opinion, IFRS is beyond repair, because it flies in the face of centuries of valuing businesses on a discounted cashflow concept,” says Rosen. The accounting lobby groups would resist the change, of course, but overseas, many are starting to realize that IFRS allows companies too much latitude when it comes to valuing assets.

Another way to improve audit quality would be to make it easier to sue auditors when they break the accounting rules or the law. At the moment, a 1997 Supreme Court of Canada decision called Hercules makes such lawsuits difficult to win, as it states that auditors don’t have a “duty of care” to individual shareholders. This decision amounts to a get-out-of-jail-free-card for the occupation. If the penalties for poor audits were higher, auditors would take more care.

Finally, the industry needs a truly independent regulator – one with teeth. Right now, auditors are self-regulated – they are disciplined by provincial offshoots of the CPA, which don’t always seem to be in a hurry when they do their investigations.

Consider the case of two EY auditors, Josephine Man and Fred Clifford, who were members of the team overseeing the books at Sino-Forest. Despite the fact that the company was accused of fraud way back in 2011, so far the CPA has not commented on the role of either auditor, and Clifford remains a partner and senior manager at EY. CPA Ontario says it is investigating Sino-Forest but refuses to explain why it’s taking so long. And so we wait – more than six years after the company was delisted from the TSX.

Clarification: An earlier version of this article was unclear in stating that Accenture was part of the parent firm of Andersen Worldwide.