Big4's Billion-dollar errors: lawyers shape-up to audit firms
AUDITORS are back in the headlines for all the wrong reasons, with two new lawsuits that will send further shivers through the halls of Australia's largest accounting firms.
Last week it was reported that a $746 million class action on behalf of investors in MFS's Premium Income Fund was being launched against the fund's compliance auditor, KPMG. The action involves KPMG's alleged failure to detect unsecured loans made to a foreign company which did not have sufficient funds to repay the sum.
Only days earlier, the shopping centre group Centro launched a cross-claim in the Federal Court, alleging that its long-time auditor, PricewaterhouseCoopers, should be held partly liable for the company's failure to adequately disclose its debt levels in 2007.
During economic booms, auditors have a jolly time of things, collecting anywhere from thousands to millions of dollars a year in fees. Share prices are rising and investors' paper profits are able to camouflage underlying problems.
It is not until things turn sour that investors start looking for people to blame. Because management often departs before any collapse, fingers are invariably pointed at the audit firm, which is paid for by investors to make sure the numbers not only add up but are accurate.
In some instances, problems which lead to the collapse of a business cannot be detected by auditors or are simply a combination of bad luck and bad management. Further, the collapse of a business is not in itself an offence; the "business judgment rule" provides that executives cannot be held liable for decisions made in good faith and for a proper purpose.
Similarly, complex fraud is difficult to detect, especially in very large businesses, because of the sampling methods used by auditors. However, in some cases auditors appear content to authorise financial statements which are incorrect, due to incompetence, personal interest or a combination of the two. As with ratings agencies, the independence of auditors has been called into question, given that they are being paid by the very people they are supposed to be monitoring.
Auditors are officially appointed by a board's audit committee to review management accounts, but in many cases that company's board is on very friendly terms with its executive team. As such, questioning the auditors' conclusions may be akin to questioning the performance of management.
That is one of the questions which hangs over the collapsed child-care provider ABC Learning Centres. For more than five years ABC's financial statements claimed it was making ever-increasing profits when, in fact, the company was losing money. It eventually announced a $437 million loss last year - far exceeding the total of all profits it ever allegedly made.
It was not until ABC replaced its long-time auditor, Pitcher Partners, with Ernst & Young that it was revealed ABC had, among other things, allegedly incorrectly been booking long-term upfront "development" payments as revenue in the year the cash was received. That had the effect of artificially inflating reported earnings.
It is certainly possible that Pitchers failed to understand the accounting chicanery employed by ABC. Or perhaps Pitchers was keen to protect its fees, audit and non-audit, which certainly provided an ever-increasing flow of money for the accounting firm's small Brisbane office.
In 2003, ABC paid Pitchers $144,000. That figure increased to $329,000 in 2005 (including about $100,000 for non-audit services) and reached $1.2 million in 2007 as Eddy Groves battled to keep his company afloat. Litigation funder IMF (Australia) is at present preparing a Federal Court class action against ABC, claiming "non-disclosure and misleading or deceptive conduct" in relation to ABC's 2006, 2007 and 2008 accounts and profit forecasts.
By contrast, the claim launched against PwC by Centro's administrators involved the principle of "proportionate liability" (Centro is attempting to hold PwC partly liable in its defence against $1 billion in shareholder class actions brought by Slater & Gordon and Maurice Blackburn). The claim against Centro largely relates to the company's 2007 financial reports. In its preliminary (unaudited) reports presented to shareholders in August 2007, Centro stated that it had $3.6 billion in long-term liabilities. In its audited statements, released in September after discussions with PwC, the company re-classified $1.1 billion of those debts as "short-term liabilities". In December of that year, Centro collapsed after revealing that it was unable to refinance $3.9 billion in debt which was due in February 2008.
It is KPMG which appears to have been most significantly implicated in a large number of high-profile collapses.
Apart from the impending action relating to the MFS Premium Income Fund, KPMG is also defending a $200 million claim against it, begun by the Australian Securities and Investments Commission on behalf of investors, pertaining to the collapse of the property group Westpoint. The suit, in the Victorian Supreme Court, alleges KPMG was negligent in its 2002, 2003 and 2004 audits of Westpoint.
KPMG's audit performances, and close relationships with clients, are also under scrutiny elsewhere. At David Coe's Allco Finance Group, which admitted to wrongly classifying $1.9 billion of current liabilities as non-current liabilities in its June 2007 financial statements, KPMG picked up $3.1 million for audit services and a further $2.9 million for non-audit related work that same year.
In addition to auditing MFS's Premium Income Fund, KPMG audited the MFS mothership (now known as Octaviar). Several senior MFS executives and employees (including former chief financial officer David Anderson and company secretary Kim Kercher) were formerly employed by KPMG. MFS's 2007 Annual Report claimed the company had net assets of $1.53 billion. KPMG found that the financial statements provided a "true and fair view of the company's … financial position as at June 3, 2007". Less than eight months later, MFS collapsed and was suspended from the ASX.
At property financier City Pacific's 60 per cent-owned satellite CP1, its December 2007 half-year financial statements (which were reviewed by KPMG), contained a basic arithmetic error - that $145 million in borrowings coupled with $6.1 million in accounts payable added up to $125.4 million.
The chief financial officer of CP1's parent company, City Pacific, was Adam Purss, who was previously employed by KPMG in its audit and risk advisory section. Purss's principal client had been City Pacific. CP1's company secretary, Lee Danahay, had also worked in that section of KPMG.
The embattled KPMG and Pitcher Partners were also the unfortunate auditors of Bill Express, which was put into administration last July owing more than $180 million - and was allegedly insolvent as early as January 2008.
In December 2007, Bill Express's financial statements, reviewed by KPMG as "true and fair", claimed that it had net assets of $66 million. Creditors are understood to have been considering legal action against the audit firm.
By receiving significant audit, and non-audit, fees yet rarely seeming to blow the whistle on problems, auditors' independence and value are cast into serious doubt.
The clamour is growing for solutions - such as having the external audit function run by a government authority, similar to the auditor-general, or having ASIC, rather than a company's board, select and appoint the auditors from an approved panel.
