[David Cay Johnston is a Pulitzer Prize winner and recipient of an IRE medal and the George Polk Award. The author of five books, including "The Making of Donald Trump," he is a featured columnist for Investopedia. The views expressed by columnists are those of the author and do not necessarily reflect the views of Investopedia.]
The latest in the endless rounds of accounting scandals, this one involving KPMG, should revive the pressure to break up the Big Four accounting firms and fundamentally reform public company auditing.
Investors need a robust competitive market for auditing, not an oligopoly. America and the world can easily sustain a dozen large accounting firms operating under strict rules requiring accuracy, integrity and individual responsibility.
In addition to more competition, public company accounting also needs two other reforms:
– an end to the pernicious Limited Liability Partnership or LLP structure, which replaced the virtuous self-regulatory incentives of the traditional partnerships with vicious incentives to look the other way, and
– a ban on auditing firms doing any consulting work.
For more than two decades I’ve warned how LLPs undermine financial integrity and encourage good people to do bad things because the incentives are wrong. Subsequent work by accounting, criminology and legal scholars has shown that behind most accounting scandals is not so much criminal intent as good people who get lured into wrongdoing by moral laxity and errors in judgment influenced by financial incentives.
A Scandal at the Top
The latest scandal involves a tip KPMG got about which of its audits the Public Company Accounting Oversight Board was going to review. The KMPG partners who got the tip should have acted instantly to notify the board, cleansing the firm. Instead they kept quiet.
The firm fired five partners for violating its ethical code of conduct. They were not small fry, but the people charged with making sure KPMG audits were fit and proper. Scott Marcello was in overall charge of KPMG’s audit practice. David Middendorf was KPMG’s national managing partner for audit quality and professional practice. A sixth employee was also fired.
But while the financial pages of newspapers treat this as a tale of individual perfidy, this is a story about institutionalized corrupting forces – policies that can be corrected.
Again and again over the past quarter century the Big Four firms have demonstrated their inability to police themselves and provide the markets with what they need – reasonable and reliable measurements of corporate finances. The latest scandal shows a systematic problem with a breakdown in moral values at the top of the accounting profession. This breakdown has broad consequences – damaging individual investors, slowing economic growth and rewarding misconduct by executives as stock prices fail to reflect actual economic performance.
Structured for Corruption
Driving that breakdown is a major change in how accounting firms are organized, a change that grew out of the savings-and-loan scandals more than a quarter century ago. At the time accounting firms were organized as traditional partnerships. That meant each partner was liable for misdeeds by any other partner.
As a result if partner Joan thought partner Jack was cooking the books for a client – or just looking the other way – Joan had an incentive to poke her nose in and ask tough questions. That’s because Joan’s personal net worth was at risk under the ancient legal theory that partners are all individually liable for the acts of each partner.
The S&L scandals could have prompted higher standards within the big accounting firms, standards that required more virtuous self-regulation to avoid losing one personal fortune because of another partner’s misdeeds.
Instead the accounting firms sought a new kind of legal structure, the Limited Liability Partnership, or LLP, with Texas lawmakers starting the trend.
Under the LLP structure Joan’s liability is limited to her stake in the partnership. Worse, the LLP structure discourages Joan from asking what Jack is up to since knowledge of misconduct could expose her to added liability depending on what she does next.
This major change in accountability created by the LLP structure took place without debate on the problems this would create.
LLPs and their structural cousins – LLCs (for Limited Liability Companies) – are significant factors in the rise of executives who run their companies as frauds to enrich themselves, contrary to the textbook economic theory that managers try to do what’s best for the enterprises they run, even if they feather their own nests a bit or evaluate risks more in terms of their personal compensation than the welfare of the enterprise or its owners.
LLPs, by reducing individual responsibility in corporate finance and especially audits, play a key role in control fraud, the criminology theory developed by Professor William Black, distinguished scholar in residence and University of Minnesota Law School. As a federal banking regulator, Black was the driving force in nearly 900 high level savings-and-loan executives going to prison for fraud. He then went back to school to develop his theory of what prompts some managers to become get-rich-quick criminals knowing they face a reduced risk of prosecution thanks to these new legal structures, the LLP and LLC.
Ever since he laid out his theory Black has been persona non grata in Washington. That fits perfectly with the vicious incentives of the LLP structure – if you don’t ask questions and learn unpleasant facts you don’t have to worry about political liability.
Had the Bush, Obama and Trump administrations listened to Black they would not have to defend their failure to prosecute corrupt bankers and other corporate executives who ran control frauds. Obama blamed weak rules rather than fraud for the 2008 economic collapse. Obama did so with a straight face he could not have maintained had he or his attorney general, Eric Holder, listened to Black. That’s how the vicious incentives of LLPs work – don’t ask and you evade personal (or political) liability.
Two Possible Solutions
The criticism I get from the accounting – and legal – professions for my decades of challenges to LLPs has been that there is no way that Joan, a partner in Tampa, can know that Jack, a partner in Spokane or SIngapore, is up to no good. It’s not fair, these critics say, to punish Joan for conduct she never know about.
The solution to this legitimate quandary is not to maintain the current LLP rules.
One solution would be to much more rigorously define which accounting employees are entitled to have limited liability – and how and when those protections can be stripped away, meaning that they stand to lose not just their stake in the LLP, but their personal net worth. Under that approach the standard for losing liability limits should be set low, not high, so the rules encourage the best behavior rather than simply trying to avoid the most egregious.
Another solution would be to have accounting firms operate through networks with separate partnerships so Joan is liable only for acts in Tampa or perhaps, better, all of Florida. Critics say that would be inefficient. Maybe so, but then offer an alternative solution.
For white-collar crimes like accounting fraud a high likelihood of detection and prosecution, conviction, long prison sentences, and being stripped of all wealth can be powerful deterrents. These are not crimes of passion, but calculated and long-running crimes where economic incentives need to apply to the crooks and to their enablers, especially public company auditors.
The Consulting Connection
The Big Four derive much of their revenue from consulting work. The now-retired head of one of these firms once tried to persuade journalists at an off-the-record lunch that without consulting work the Big Four could not be successful enterprises. There just was not enough money in auditing, he said.
“Not true,” I said. Since auditing is required for companies with stock or publicly traded bonds, the fees companies pay would have to rise to the level needed to attract the talent to do the work.
The Big Four chief agreed, then added, “but we wouldn’t be able to make nearly as much.”
That is the very definition of how institutional corruption works. The prospect of big fees for advising firms corrupts the crucial audit function. The answer is to ban auditing firms from doing anything but audits.
Some partners of the existing Big Four (and second-tier firms) might leave over that, but so be it. They would then be free to seek work as consultants in a market unpolluted by mixing auditing and consulting. The consulting fees, I suspect, will shrink once these two lines of professional services are separated.
The issue here is that public company audits need to be reliable. We need competition. Having just four big firms is already anti-competitive.
Most importantly, we need to get the incentives right. That means revising liability limits for accounting-firm partners in ways that create incentives for asking hard questions when even a hint of auditor misconduct arises and banning consulting so the work of auditors is not polluted by a desire to sell business advice. In short we need focus on the three things that matter in corporate audits: accuracy, integrity and responsibility.
David Cay Johnston's latest book, "The Making of Donald Trump," was published on August 2, 2016. His next one will be "The Prosperity Tax: A New Federal Tax Code for the 21st Century Economy." Johnston is a Distinguished Visiting Lecturer at Syracuse University College of Law and Whitman School of Management, and also writes for The Daily Beast and Tax Notes.