Auditor Independence: Lessons from KPMG South Africa & Other Scandals

Posted on November 27, 2017

Raul Dimitriu
Raul Dimitriu
Senior Associate, Corporate Governance Research

A good reputation is arguably one of an audit firm’s most valuable assets. But when auditor independence is compromised, it can have very negative consequences for the relevant stakeholders and, in extreme cases, it can even undermine the public’s trust in a country’s financial system. Recent controversies at Tesco and BT Group, involving PricewaterhouseCoopers (PwC), have led to the unprecedented termination of important business relationships going back three decades. KPMG South Africa’ involvement in a political corruption scandal is also proving to have even more far-reaching implications, which risks impacting KPMG’s international operations. In this blog post, I will delve into these controversies and highlight the mechanisms that can help to preserve auditor independence and maintain a strong reputation.

Tesco and BT Group terminate external auditor prematurely following earnings overstatements

It is not often that the CEO of a market leading company is called to testify at a criminal trial. Yet, this is what happened on 2 November 2017 when Tesco’s CEO David Lewis testified at the trial of three former top executives, namely: Carl Rogberg, Christopher Bush and John Scouler. The fallout from the profit overstatement scandal, which originated in 2014, also hit PwC, Tesco’s external audit firm, whose term was prematurely terminated after 32 years.

The former Tesco executives were charged with false accounting and fraud in 2016 and face up to 10 years in prison if convicted. At the trial, CEO David Lewis told the court of “surprise” and “shock” after receiving a whistleblower report from Adrian Morris, Tesco’s top lawyer, just weeks after taking on the position in 2014. The report pointed to a GBP 250 million profit overstatement that year. After the finding was verified and made public, the company’s market value dropped by GBP 2 billion.

Despite not being found liable by the UK’s Financial Reporting Council, Tesco and PwC agreed that PwC should step down as the external audit firm in FY 2015‐16. In March 2017, Tesco agreed on a settlement of GBP 85 million to be paid to investors to dispose of market abuse charges. In the same month, the company also concluded a GBP 129 million settlement with the UK’s Serious Fraud Office.

PwC was implicated in the BT Group scandal in January 2017 when it was reported that BT Italy had committed accounting errors that led to the overstatement of earnings for several years. The required adjustments were valued at around GBP 530 million with the public disclosure thereof leading to BT losing a fifth of its market value. PwC failed to uncover the misstatements and BT decided to terminate its relationship with them in June 2017. The end of the 33-year relationship was not the end of the bad news for PwC. The UK’s Financial Reporting Council subsequently launched an official investigation into the firm’s conduct.

In both cases, the scandals led to the unprecedented termination of important business relationships that had lasted more than three decades. This sends a strong signal to the market, but PwC should be able to weather the storm of bad publicity, and its reputation should recover in time.

KPMG South Africa faces unprecedented crisis

In the past three months – in an unprecedented move – more than 10 major corporate clients have dropped KPMG South Africa as their external auditor in response to KPMG’s involvement in a major political scandal. By 10 November 2017, the entities that had suspended or terminated KPMG’s audit engagement included: Munich Re, African Rainbow Minerals, South Africa’s Parliament, Sasfin, The Foschini Group, Business Leadership SA and Telkom. Barclays Africa, Investec and other banks are reportedly reviewing their contracts with KPMG.

On 15 September 2017, KPMG disclosed that an internal investigation had found shortcomings in the auditing of companies owned by the prominent Gupta family. The internal probe revealed that KPMG South Africa had ignored concerns raised over the integrity and ethics of the Guptas’ business dealings, and that KPMG should have terminated its client relationship with the family earlier than March 2016. Problematic dealings specifically mentioned in the report included work on the Guptas’ purchase of a coal mine, and the attendance of a Gupta family wedding by four KPMG partners. Since 2014, the Guptas have been embroiled in allegations of having relied on key relationships with the South African government to influence government appointments and to secure major state contracts. The family is known to be close personal friends with South African President Jacob Zuma and to have engaged in business with one of his sons.

KPMG South Africa has also been widely criticized for its report that falsely asserted the existence of a “rogue spy unit” within the South African Revenue Service (SARS). KPMG conceded that its report wrongly implicated the former Finance Minister Pravin Gordhan in alleging that he negligently endorsed the “rogue unit”. Financial media widely stated that the report was a trigger for Gordhan’s premature removal from cabinet.

South Africa’s Finance Minister Malusi Gigaba called on the Independent Regulatory Board for Auditors to sanction those responsible for wrongdoing. In response to the ongoing controversies, KPMG International Chairman John Veihmeyer stated that the firm would appoint a legal representative to conduct an independent investigation into KPMG’s South African operations and the company’s management and corporate governance structure underwent a major overhaul.

KPMG South Africa recently announced the resignation of nine senior executives, including the CEO Trevor Hoole and the COO and Risk Management Partner Steven Louw. Additionally, the company reported that it would appoint a senior independent (lead) director to the board and that it would separate the COO and Risk Management roles to ensure that the Risk Management Partner can commit sufficient time to risk oversight.

Audit reporting controversies, like the KPMG South Africa scandal, can have serious consequences for a country’s reputation. In September, South Africa dropped significantly in the World Economic Forum’s Competitiveness Index Report for 2017-2018, from 47th to 61st out of 137 countries. This can partially be ascribed to its drop in the audit and reporting standards ranking, where it fell from first to 30th place. This is a drastic drop, considering that South Africa had been ranked first in this category for seven consecutive years.

The importance of auditor independence for credible financial statements

Financial reporting controversies undermine the public’s trust in the sector, leading to lower market participation to the detriment of the investment community. Investors need credible financial statements to operate efficiently, and they run the risk of potential financial losses from misstatements. Without credible financial statements, markets become less transparent and capital is not allocated optimally, which negatively impacts society. This places an important responsibility on an auditing firm and highlights the importance of safeguarding its independence in order to build a strong reputation.

Audit firm rotation is widely seen as an important way to promote auditor independence and recent accounting scandals have led to growing calls for mandatory audit firm rotation. Proponents argue that without rotation oligopolies may undermine auditing standards and independence. Opponents argue that rotation will result in mandatory tenders, which could create the risk that audit firms are increasingly selected based on cost as opposed to expertise, resulting in the commoditizing of audit fees.

As the KPMG scandal was unfolding in South Africa, the country’s Independent Regulatory Board for Auditors implemented a new mandatory audit firm rotation rule in June 2017. Effective as of 2023, the new rule requires audit firm rotation every ten years. The European Union has already implemented mandatory rotation (Regulation 537/2014) in 2016 with companies being required to change their external auditor every 10 years. The UK has chosen to exercise a permitted derogation of this law, which only requires firm rotation every 20 years (subject to a new tender every 10). The United States, on the other hand, does not have mandatory firm rotation, with the rotation requirement applying only to the audit partner.

Unsurprisingly, the Big Four accounting firms – KPMG, PwC, EY and Deloitte – have come out against these regulations. Together with two other firms, the Big Four perform 90% of audits of listed companies in South Africa and the new regulation is likely to cause some waves in the country where the largest company by market capitalization, Naspers, has held the same audit firm for 102 years.

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