Finance should be a servant, but never a master.
So when accountants and auditors become the story because of systemic failures and corporate malfeasance you know something has gone badly wrong. As big accountancy firms are increasingly embroiled in corporate scandals, how do we clearly define their role so they actually serve society instead of continually maximising profit for private and personal gain?
Host Ross Ashcroft is joined by Oxford Business & Public Policy Professor Karthik Ramanna and Professor Atul Shah, whose speciality is Accounting & Finance at the University of Suffolk.
As if not to be outdone by banking crises, the accountancy profession has gone to extraordinary lengths to trash its reputation and industry. The big four used to be a hallmark of trusted reliability, yet now that term is synonymous with scandals and conflicts of interest.
Joining us to work out why bean counters are staring into the abyss are Oxford Business and Public Policy Professor Karthik Ramanna and Professor Atul Shah whose speciality is accounting and finance at the University of Suffolk.
Now our viewers are watching this thinking this lot are going to bang on for half an hour about accounting. How interesting can that be? Actually it’s incredibly interesting.
Professor Ramanna tells Renegade Inc. that accounting is like the plumbing in the capital markets.
“If it’s working well and it’s doing what it’s supposed to do, you really shouldn’t be noticing it,” he says. “But when it doesn’t work well it becomes so patently obvious and that’s why it’s interesting. And we’re living in a time now where it isn’t working so well.”
Not a day goes by now without the newspapers covering one of the Big Four or an accounting firm, not doing what they should be doing.
“Indeed,” says Ramanna. “And this is a really serious issue for us as a society but it’s also obviously for people who are engaged in the study and the stewardship of capital markets a particularly salient concern.”
The professor has written about the seven deadly sins of accounting. When you think about the trouble with the big four, pick out your best three of the seven deadly sins of accounting.
“The seven deadly sins referred to those associated with the audit profession more broadly, some of which implicate the big four and some don’t,” he says. “I’d start by saying part of the problem here is what I call ‘a captured market’, in the sense of one has to buy the product, and that obviously has implications on the supply and the quality of the supply, which leads us into the second problem which is that it’s effectively a commodity product.
“Auditing shouldn’t be a commodity. In fact as you look at the world of artificial intelligence and how it’s going to change the nature of human productivity, auditing is one of those professions that can transcend and survive because it’s inherently about human judgment.
“For better or worse – mostly for worse – the nature of auditing today is largely a commodity.
“I’ve written about how the analogy here is a restaurant critic effectively writing restaurant reviews that say ‘the food here doesn’t suck’. That’s effectively what audit reports nowadays are about. They effectively say ‘well this company is not going to fail’. Of course, sometimes they’re quite wrong about that which is a serious source of concern.
“A third issue here is the fact that the people who actually need the audit, who actually use the audit: the shareholders, the wider constituents in the corporation, whether they’re customers or society at large, they’re not the ones who are commissioning the audit. Nominally, the audit is commissioned by the board of directors, by the audit committee of the board. But in practice that decision is largely influenced by management, in particular the CFO and the CEO. Again you’ve got a mismatch between the person or the people who are making the purchasing decision and the people who are using the decision.”
For instance if there’s an investment manager looking after a pension fund. The professor is saying that it’s possible that they’re not getting 20/20 vision on how good that company really is because of a weighted decision within that business of who to use to audit it.
“In fact, one of the things that one would really have hoped for in this market is that investment management firms and other asset management intermediaries would have taken a more important role in forcing boards and corporate management to take the audit function seriously,” he says. “For a number of reasons that hasn’t happened, and effectively this decision has vested in management. Of course, management has its own incentives in what an audit should look like.”
With that in mind, why haven’t the investment community said no this is way too cozy? Because one of the points that the professor raises is that the Big Four are politically very powerful. They have a monopoly position. Why hasn’t the investment community said ‘enough’s enough. We actually need to break this up because we need greater transparency and greater insight to what’s really going on in these companies.’
“Part of the problem is the incentives in the investment management industry,” the professor says. “The way the investment management industry has been set up, a lot of the pay and the compensation depends on what’s called ‘relative performance evaluation’. So rather than being held for accountable for absolute returns, they’re just held accountable for returns over some sort of relative benchmark. That’s created all kinds of perverse incentives for asset managers.
“Again, a number of norms or rules are set in place where asset managers get very handsome rewards for effectively very little work.
“If you look at the empirical evidence on the act of the Asset Management industry, most active asset managers don’t produce any value. They can’t do better than a broad based index fund over any long period of time.
“And yet, of course, they charge these ridiculously high fees that allow them to make out like bandits. Where is the incentive really for them to solve this problem?”
Professor Atul Shah tells Renegade Inc. that Britain is one of the countries that actually created the oldest accounting professional body starting from Scotland, then England and Wales.
“At that time, to be a professional and not a businessman was considered a matter of pride,” he says. “You were a gentleman when you’re a professional and if somebody called you a businessman you would see that as an insult,” he says. “Today the coin is completely flipped. So these professionals are first and foremost businessmen and they are very profit oriented and they use the professional title as a badge, as and when it suits them, but they do not carry with that title the kinds of values and culture and conscience that is required to be a good auditor and a good accountant.
“The Big Four are absolutely open about this, that they are profit oriented businesses. If you look at the figures the consultancy arm is much bigger than their auditing arm by far. It’s about two thirds, one third. Also they generate a lot of revenue from tax -what they call tax planning – but what you and I know is the tax avoidance industry. And actually the more fundamental thing is that, at least in the UK, my research shows that there is no single Big Four audit partner who is purely dedicated to auditing. They are being monitored as you rightly said incentives. They are being incentivised by the fees that they generate.
“So what happens during an audit, if you think of the mindset of an auditor, it has to be a skeptical mindset, it has to be a suspicious mindset. But instead it’s become a friendly mindset. And of course the audit allows them straight into the boardroom through which they can sell the other services, and that’s why they don’t want to give up auditing.”
Professor Ramanna says there is a very serious conflict of interest between the sale of so-called non audit services and auditing.
“Auditing as Atul mentioned requires a degree of skepticism and requires, in some sense, the person to be absolutely independent of the corporation,” he says. “But if you’re in the business of providing IT services, tax services, consulting services, business advisory then of course that’s going to compromise the level of scrutiny that you provide. This is a very serious issue that we’ve actually tried to address a couple of times through major regulatory change, but each time we thought we’d gotten close to this, the power of the Big Four, again they sort of engineer the rules of the game.
“The term regulation only makes sense if it’s actually working in this context. I think there is increasing evidence to suggest that it might not be and we need to look at other forms for which we can structure the rules of the game in this market.”
In his study of the failure of HBOS, which is the largest corporate failure ever in British history, Professor Shah found throughout was that the board of directors never respected the regulator.
“If you think fundamentally a banking licence is not given to everyone, it’s only given to a certain organisation who fulfil certain criteria,” he says. “It’s a privilege license.
“HBOS took that privilege and basically ran the bank into the ground by maximising profits and risk at the same time.
“James Crosby, the first CEO, was a board member of the Financial Services Authority, the main regulator, whilst he was CEO of HBOS. He was widely known to be critical of regulation, and to prefer ‘light touch’ regulation. He was invited into the board. He later rose to become knighted and vice chairman of the Financial Services Authority. So when you talk about capture, when you talk about influence, it’s almost as if even the regulators actually invite these people right in. And then, of course, the moment he joined the board my research showed that the scrutiny of HBOS reduced.
“Prior to Crosby joining the HBOS board and the Financial Services Authority, the regulators were very worried. In fact they called it an ‘accident waiting to happen’.
“In 2004 there was a famous whistleblower called Paul Moore who cooperated fully with my research and he said this organisation is growing too fast, cannot manage its risks, it needs to be curtailed, its strategy needs to change. He was fired by the CEO, by the rules prevailing at that time, his sacking had to be independently verified.
“Guess what HBOS did? They called their own auditors, KPMG, to ‘objectively’ verify the firing of their head of risk, that this was not motivated by his challenge, but it was motivated by other reasons. And here’s how the story becomes exciting: He himself, Paul Moore, was a senior partner in KPMG before he joined HBOS. Talking about conflict of interest. The HBOS story was riddled with conflicts of interest and the regulator chose to rely on the KPMG report saying that he was fired because of his personality and not because of his challenge. The result of that is that we, the public, lost £52 billion of taxpayers money without actually signing the cheque for that amount.”
This hopelessness that people feel when they hear a story like that. How do you begin to say to people well, actually, there’s a way to solve this?
Professor Ramanna says it’s really incumbent on people who have invested the time and energy in understanding the issues to either step away from the positions that would compromise them if they’re going to take a role in providing public solutions, or we need a systematic rethink of the way we organise the regulations and capital markets more broadly.
“I’ve written about the role of experts in this issue and one of the things that is absolutely true about accounting and auditing is that it is, in fact, an expert driven profession,” he says. “But from time to time having a breath of fresh air in the boards, in the regulatory agencies that govern these markets, is probably not a bad idea. At the end of the day having someone who brings a healthy dose of skepticism and the capacity to just ask pragmatic commonsense questions is probably something that can be very valuable in these settings. So some of the most useful questions that you get in a classroom conversation for instance on things like ‘what caused a financial crisis’, or ‘why did Enron fail in 2001’ is a question from people who simply raise up their hand and say ‘I don’t understand’. Explain this to me, I have a PhD in physics and I simply don’t understand how this is a viable business model.
“Bringing in so-called non-experts but people who have the capability to and the credibility to ask those questions and the confidence quite frankly to ask those questions of experts can be refreshing and helpful.”
Before we talk more about accountancies epic fall from grace with Professor Karthick Ramanna and Professor Atul Shah. Let’s have a look at what you’ve been tweeting about in this week’s Renegade Inc. index. First up we got a tweet from SME alliance: “Seems like the Big Four audit firms are making the news headlines on a regular basis. PwC braced for record fine over audit of BHS.”
Why are we seeing these firms persistently splashed across the newspapers.
Professor Shah says a fine has become a cost of business.
“And the point about professionals and standards and ethics, out of the window.”
Next from journalist and author Ian Fraser: “The big four accountants earn billions from the public sector. Their incentive not to blow the whistle on flawed business models is obvious.”
Next up we have another tweet from Ian Fraser: “KPMG is now facing collapse in South Africa, raising serious questions about the role of Big Four firms in providing a veneer of legitimacy while enabling corruption.”
Professor Ramanna says there’s a serious question to be asked and answered about the culture that has been created at the big four.
“In particular the emphasis on their stewardship function in the economy and whether the corruption in terms of the conflicts of interest created by the non audit services is really sort of eroded away that sense of public responsibility and duty that they have to markets and society more broadly.”
Finally a tweet from Ayush Jain: “Just four major global firms audit 97% of US public companies and all of the UK’s Top 100 corporations. This is pure cartel. Who’s going to do the audits of these big four firms?”
Professor Shah says the actual answer is that the next level of four firms after that are actually auditing the Big Four firms. “So for example KPMG’s auditors are Grant Thornton.”
So it’s your big eight?
“Not only that it’s their friends auditing their friends essentially, right.”
Our Book of the week this week is Reinventing Accounting and Finance Education. It’s written by professor Atul Shah. Pitch it to us. Why should we buy it?
“Education and training of accounting and finance professionals is a multi billion dollar global industry,” says Professor Shah. “Yet it’s actually very formula driven. It’s very technical and in one sense it actually insults a culture and ethics of the students who consume it. Whilst we are talking about these serious accounting scandals that are happening and they are in the news everyday. One of the sources of the scandal is the way these professionals are being trained and educated in the universities, the business schools and the professional bodies of the world.”
His argument is that that’s too technical and there isn’t an ethical bent or there isn’t a philosophy.
“Oh yes absolutely,” he says. “Now with all these scandals they’ve started to put in some ethics as a kind of sideline into this education. But again if you look at how the ethics are being taught, it’s again formulaic, it’s rule based, it’s technical, and does not engage with the diversity of the student base. It doesn’t engage with their cultural upbringing. There is no scope for any religion or faith in any of that.
“Anthropologist, David Graeber has done a fantastic five thousand year study of global finance and he says faith has been at the heart of finance for five thousand years. Why? Because finance is primarily about trust and people who have faith are afraid to deceive others because they know they will be judged when they go up there. So they become self regulators.”
Renegade Inc co-founder, Megan Ashcroft was selected to become part of the KPMG cadetship program after finishing school, quite a prestigious offer, because after four to six years of study she would come out the other end a chartered accountant, able to apply business principles and practices to a wide range of small to large institutions.
“That knowledge of business and accounting, I thought would then allow my entrepreneurial skills to shine and be, I guess, honed in that sense of accountancy,” she says. “The reality of being a chartered accountant coming through that process was really two main things: One is that you have to hit time sheets and chargeable hours. A lot of it is profit maximisation, as straight as you can charge. The second is that I was on a process within the organisation where I couldn’t set a precedent. I couldn’t ask questions outside of my trajectory. All this was set against a backdrop of performance appraisals which started after each client job, each quarter, and again annually. What it was there to do is to make sure that you fitted into four or five company values. If you excelled in something that wasn’t a company value, that was pretty discouraged because you needed to be in the box.
“What many people might not realise about finance and especially about a chartered accounting experience is that it’s a very prestigious profession to have. So you start in a Big Four house. Then if you choose not to progress to a partner level, which many people don’t, then you will then spin off into industry. Now, the main places that you go is to a client that you’ve worked for, because you have a relationship and they like you. So then you go and work for your client’s side, or you’ll go into the financial services institutions: big banks, insurance industries, etc. And so what you have is a lot of people who know each other working in the same industry but on different sides, all coming from a chartered background.
“I found myself part of that revolving door, working for investment banks in London, part of a group of risk assessment teams Sarbanes-Oxley, internal audit, external audit, risk departments, really rubber stamping processes that made sure people weren’t going to question the amount of risk and the exposure of risk in siloed departments within a whole institution.
“And on the eve of the 2008 financial crisis I had a big question about the whole industry, when, after all the uptick in the market where all the investments were marked to the market, happily taking the profit going up. When exposure was going to be questionable, the accounting profession said you can all mark back to the model. We’re not going to take any of the downside. Don’t worry about price discovery any more, you can mark to your models. I think, for me, that was the moment I said ‘I don’t want to do this anymore.’”
Let’s talk about culture because when we look at finance we don’t get too far down the track when you’re thinking about these organisations when you think well actually there’s a toxicity. How do people behave in these ways? There are perverse incentives and that drives certain behaviours. But if we wind it back and just talk about the culture within the Big Four and wider. How do you perceive it at the moment?
“Professor Laura Empson of Cass has done a wonderful study on the culture of big law, accounting and consulting firms internationally,” says Professor Shah. “She’s interviewed 500 partners across the world on this and she’s summarised the findings by saying that they hire people who are insecure. They increase the insecurity whilst they’re in the firm, and then when they become partners they constantly feel they have to prove themselves. They have to work all the hours. And she’s saying that they are becoming drained out by all this pressure.
“There is a latent mental health crisis amongst the leadership of these firms. In some sense greed and insecurity are twins.
“The more we have increased greed, we know it’s a very basic science of wisdom, that the more we possess the more we become possessed. I think that basic science needs to be communicated in the world today and people need to see that security does not come from wealth or possessions, but from self confidence, family and self love.”
That is absolutely toxic. How can you make decent leadership decisions when you’re swimming amongst that tide, if you like?
Professor Ramanna says there is indeed a cultural problem in large professional service firms like the big four.
“But of course that problem, the problem around greed, is a much wider issue,” he says. “In some sense this was a shift in the public’s understanding of what capitalism is and how we engage in capitalism.
“It is a broader problem associated with economics as a profession, as an academic discipline and it’s a problem associated with how people engage with capitalism as a system for economic organisation. The famous 1980s movie Wall Street with the Gordon Gekko’s mantra: ‘Greed is good’. That really encapsulated the issue in the Big Four right now. Indeed there is a problem in the Big Four but I think we also have to take a step back and say it’s not just them. It’s a much wider societal problem that we’re dealing with.”
How do you begin pragmatically to work towards saying do you know what we’re better than this?
“I do it all the time in my classroom,” says Professor Shah. “I ask my students to bring in their own personal experiences and stories of finance whether through the family or them as individuals. Bring them into the classroom and you find that suddenly they become motivated to learn the subject. They find that their own experiences are not dismissed. Very often today’s young generation is being exploited by finance left right and centre. So very often they are sorry tales, but when we bring and then we discuss them they begin to see how culture and finance are deeply entwined and that to study finance without culture, without narrative, without bringing people’s personal experiences is actually fraudulent.”
Professor Ramanna says education plays a very important role in teaching but also in the production of new knowledge.
“Part of the reason why neoclassical economics has been so successful is that it has provided within the context of certain assumptions a coherent axiomatic framework to understand the macroeconomy. Those assumptions might have been valid at the time that this framework was first conceived shortly after WWII, but there is increasing evidence to suggest that the conditions, the political, economic social conditions we live in today, are quite different from those embedded in the assumptions and so the need for an alternative framework is clear.
“There’s a role here for advancing scholarship, building a new coherent intellectual framework that allows us to understand complex phenomena like the economy. There is also an important role for public leadership. One of my roles is to serve as the director of the Master of Public Policy Program at the University of Oxford, and we are in a fortunate position where we can convene 120 students from over 60 different countries. This is an incredibly committed group of individuals and working with these individuals as they are in positions of government to raise the issues with the population, to raise the issues with people who experience, in some sense, the dark side of capitalism so that they have a sense of how they might be able to navigate this.”
Professor Shah says one of the subjects which our film, Four Horsemen, covered so brilliantly was the environment in relation to these problems. “And today we haven’t spoken about the environment,” he says. “Once we bring environment into finance it teaches us a tremendous amount of humility. It teaches us how arrogant finance has become. Today finance is a prime cause of the destruction of nature, through the film The Corporation where Joel Bakan says that the modern corporation has actually become psychopathic and we are seeing all this evidence.
“In fact the Big Four firms are giant corporations in their own right. So we also must have a kind of holistic education which actually encourages students to see the human species as just one of the species on the planet. And if it has only one responsibility and duty it must be as a trustee of the planet and not as a master of the planet.”
Professor Ramanna says he does not agree that the large corporations or the big four even for that matter are psychopathic.
“I would argue that there are issues with the big four and with corporate behaviour more broadly but by you know by and large no other system of economic organisation has produced a level of prosperity than capitalism, whereas capitalism has,” he says. “I mean if you look at the introduction of free markets in places like China or India over the course of the last 30 years. I mean in China alone free markets has lifted hundreds of millions of people out of poverty. So audit firms, despite all of their deficiencies and I’ve written extensively about them, do create value in society just as corporations do create values in society. I hope the message from all of this isn’t that we throw out the audit firms, that we throw out corporations, because that’s certainly not something that I think would do… would serve us very well.”
Passion, pragmatism. What more do you want? You see it wasn’t a boring half hour on accountancy. Gentlemen thank you both very much.
In the era of apparent endless money-supply, are we any closer to understanding what money really is?
Is the pandemic being used as weapon to bleed students dry and to boost the money-making opportunities of the powerful?
Decades after the formal ending of a brutal, racist apartheid system, South Africa is faced with political corruption and corporate plunder.