Big Four Auditors and Consultants Need Liability—And a Divorce
April 4, 2023
It’s hard to ignore the fingerprints of a Big Four accounting firm—as well as the office nameplates in the C-suite—in the high-profile collapses of Silicon Valley Bank and Signature Bank, as well as the near miss at First Republic Bank. In a veritable coup de grâce to independence, KPMG drafted audit opinions signing off on the banks’ financial statements.
While it may be difficult to point out what should have been done to avoid the financial upheaval of the last few weeks, it’s not difficult to point out who should have done something.
There’s a legal concept that arises in tort contexts called res ipsa loquitur, which means “the thing speaks for itself” in Latin. The canonical example is a surgical patient who has a tool or sponge left inside them. The idea is the hospital can’t claim they didn’t act negligently, because the “thing” speaks for itself. A sponge isn’t supposed to be inside the body, so its presence, coupled with its provenance, proves negligence.
In actual practice, the use of res ipsa loquitur is rare. But using that premise, see if you can make a connection with this set of facts: Two weeks after KPMG signed off on Silicon Valley Bank’s fundamentals, regulators shuttered it and placed it into receivership.
On Feb. 28, 2023, KPMG signed off on First Republic Bank and gave it a clean audit opinion. By March 16, First Republic needed a $30 billion emergency injection of capital to stay afloat. Signature Bank got an all-clear from KPMG 11 days before regulators said, “Hi. You aren’t a bank anymore.”
While we may not be able to put our finger on exactly what KPMG did wrong, something is amiss. If regulators are leaning on the Big Four to handle audits of corporate financials, and those audits aren’t gleaning the kinds of information they’re intended to, it raises serious concerns about the effectiveness and reliability of said audits. We’re looking at the X-ray, and there are definitely six scalpels and a retractor in there. So what’s to be done?
The Need for Liability
First, there needs to be liability placed on the accounting firm tasked with acting on behalf of a regulator when that organization fails to identify indicia of, at least, questionable financial health. And make no mistake, Silicon Valley Bank had clear indicators of potential issues; it was heavily invested in 10-year bonds, which limits access to liquidity and returns on investment of those holdings. First Republic and Signature Bank depositors saw an over-representation of venture capitalists and, as they were dependent on cheap money, they were vulnerable to rising interest rates.
Part of the problem is the revolving door of personnel between the major accounting firms and the banks they purport to audit. Signature and First Republic were both led by former KPMG partners, and KPMG was the auditor for Silicon Valley Bank for nearly 30 years. Could relationships form that give rise to conflicts of interest when it comes to telling a colleague of nearly three decades that there might be precariousness hiding in their books? I can imagine it.
Further, accounting firms have no incentive to draw attention to potential problems, rather than just explicit and clear problems, because it may trigger just what happened anyway. Banks with high average deposits and relatively few depositors are especially at risk, as they may be a conference call with a few dozen participants away from seeing a sizable percentage of their deposit base pull their money.
That’s no excuse for auditors not to disclose that risk, and individual firms only will have cover with market-wide full transparency disclosures. The bottom line is that given the cozy relationship between accounting firms and the banks they’re auditing, KPMG and the other Big Four are acting rationally when they sign off on corporate financials that may have some potential risk.
But they aren’t at risk of ceasing to be a going concern. They’re house inspectors that have formed a relationship with the selling agent, and they see no financial upside in telling a prospective buyer that a given house has water infiltration issues and a rodent problem. They recognize their liability realistically begins when things start to collapse—so they’ll disclose dangerous wiring and look the other way on the attic vermin.
The task, then, is finding a way to channel that rationality to incentivize auditors to give real, unbiased, and complete audit reports. The most obvious answer is to figure out why they don’t want to upset their bank-clients with an emphasis-of-matter paragraph on their over-reliance on venture capital funds—money.
The key will be making auditors liable for failing to draw sufficient attention to aspects of financial statements that should require conveyed caution. At the absolute least, accounting firms that make de facto poor audits should be forced to return their fees to the banks in question to help make depositors whole.
Consultants Can’t Wear Auditor Hats
An accounting firm often will act as both a consultant on the bulk of transactions entered into by a bank and the auditor of those transactions. If you thought not wanting to lose a sweet auditing gig was motivation to give a thumbs-up on financials, imagine if your firm—your colleagues—were responsible for structuring much of the underlying deals that gave rise to those financials. And perhaps a former colleague is the CEO of that bank.
The simple (not so simple) solution here is a blanket ban on a firm consulting and auditing the same client. Deloitte steadfastly has refused to consider such a split, while Ernst & Young is struggling to split most of its consulting and tax business into a new company.
The problem is that there may not be enough diversity in the market to allow that to be achieved easily. Market forces create or destroy competition, so there never will be sufficient competition as long as the hat trees in the Big Four offices contain so many hooks.
The recent bank collapses didn’t stem from single issues, so they don’t have single solutions. The financial sector will never be devoid of risk. But it’s high time that we spend the period after a set of these collapses at least attempting to make changes. Let’s hold them to account and not wait for the next, more widespread, collapse.
[Bloomberg Tax]
