Last week, the Public Company Accounting Oversight Board held its first public hearing relating to its 2011 findings that all of the Big Four CPA firms [Ernst & Young, KPMG, Deloitte & Touche and PricewaterhouseCoopers] have failed to follow generally accepted accounting principles and frequently lack independence from management.
At the hearings, two of the former chairs of the SEC provided particularly critical analyses of the problem created by the oligopolistic hold the Big Four have on every industry in America, including "too-big-to-fail" banks and other major banks subject to regulatory stress tests.
All banks subject to the stress test are audited by a Big Four firm. Some have had the same auditor for a generation or more. In fact, the PCAOB's own internal study demonstrates that over 70% of the market capital of the banking industry is audited by the duopoly of Ernst & Young and KPMG.
Our organizations, as well as the Latino Business Chamber of Greater Los Angeles, met last month with senior officials at the Federal Reserve, the OCC, the FDIC and Treasury to discuss their growing concerns that the stress tests might be inadequate due to the lack of independence of the Big Four firms from their "too big to fail" clients. (In approximately half of the Big Four's audits, according to the PCAOB, they failed to follow generally accepted accounting principles.)
The three minority business groups in their testimony before the PCAOB last week stated that they shared growing concerns as to the oligopoly controlling the financial analyses presented to regulatory bodies in their stress tests. Some experts at the PCAOB hearings voiced concerns suggesting that these negligent practices could lead to financial scandals that recently created a crisis in Iceland, Ireland and Greece.
Paul Volcker also expressed a seemingly controversial suggestion to ensure independence of large CPA firms from their clients. He suggested that the PCAOB consider an alternative to allowing companies to "buy" their auditors. Consistent with Mr. Volcker's concerns, we would urge the PCAOB to consider collecting a pro-rata fee, analogous to the FDIC-insured deposit fee, from all Fortune 1,000 corporations. The auditor's fee would be negotiated by and paid by the PCAOB. The companies, however, would be permitted to choose their own auditor.
The larger problem, however, is that there are no real choices today. In fact, there is a duopoly not only in the banking industry, but in virtually all other industries, such as high tech and utilities (for example, 91% of public utilities market capital are audited by Deloitte & Touche or PricewaterhouseCoopers).
As these minority business groups informed the antitrust divisions of the DOJ and the FTC in their February meetings, the DOJ and the FTC could seek to break up these oligopolies, but a far more effective and expeditious free market option exists. The federal government, which annually awards $500 billion in contracts to corporations, could prohibit contracts to corporations that use a CPA firm that fails to follow generally accepted accounting principles or lacks independence from management.
If the Obama Administration initiated this action by issuing a presidential executive order, there would be between 25 to 100 CPA firms competing for this lucrative corporate business within two years. (Last year, the Big Four had global revenue of more than $100 billion.)
As the DOJ is aware, CPA firms are not a natural oligopoly or duopoly. The legal profession is a graphic example. Over 100 law firms compete for business with Fortune 500 corporations and size is not the determining factor in who succeeds.
Francine McKenna recently pointed out in her BankThink column "The Little We Know About Foreclosure Reviews Is Troubling" that the dominance of Big Four firms affects far more than just the audits that are used in the stress tests. They affect, for example, who the consultants and advisors are to the fourteen largest servicers involved in the Federal Reserve/OCC consent order relating to loan modifications and foreclosure remedies. Specifically, the senior advisors to five of the 14 servicers are Big Four CPA firms that use questionable accounting practices and are not independent of management. The affected financial institutions are Chase, Citigroup, HSBC, Metlife and U.S. Bancorp.
PCAOB Chairman James Doty informed the National Asian American Coalition at the conclusion of the hearings on March 22nd that there would be additional public hearings and that he was contemplating having the next public hearing in San Francisco. The California Public Utilities Commission, headquartered in San Francisco, is also presently considering its own investigation relating to $18 billion in proposed ratepayer increases by three utilities audited by Deloitte & Touche and PricewaterhouseCoopers (PG&E, Sempra Energy and Edison).
From both the Obama Administration and the minority business perspective, there was one other undiscussed advantage of breaking up this oligopoly. It could end the dominance of the white "good old boy" network that presently dominates the Big Four.
Mia Martinez is the chief deputy for the National Asian American Coalition. Robert Gnaizda is counsel for the Black Economic Council and former general counsel for the Greenlining Institute.
See related BankThink piece: "How to Put More Distance Between Banks and Their Auditors"