[Preamble: South Africa has spent the past year playing host to a parade of accounting and auditing scandals. Many of the audit firms are affected, but KPMG has been caught up in two big ones: the Gupta/State Capture saga, and last week, the VBS banking story. Full disclosure: I’m one of the CA(SA) crowd, a member of SAICA, and I was once an auditor myself. I didn’t really love audit – and usually, I’m happy to admit that there are things that we get wrong. But I’m actually on the audit profession’s side here – and I would like to explain why.]

There is a lot of outrage about the behaviour of (some of) South Africa’s chartered accountants. SAICA, our representative body, is constantly attacked for its slow responses to the news stories as they break. And the competing accounting bodies (like SAIBA) seem delighted to assist with a well-spiced sound-bite.

If there is anything that I want you to take away from this post, it is these three things:

1. Our outrage is not specific enough (ie. we’re angry with the audit profession as a whole; instead of those bad apples that have infiltrated the audit firms);
2. Our capitalist economies are built on accounting and auditing – but the system of commerce has scaled to such a degree that it’s hard to see how and why; and
3. South Africa’s audit profession has been going through a period of adjustment that was almost inevitably going to result in these kinds of scandals.

Let’s start with the bad apples.

PART 1: APPORTIONING BLAME

When financial crime happens, whose fault is it?

Here’s an analogy:

1. Let’s say that you live in a neighbourhood that has a lot of break-ins. Concerned that your house might be burgled, you ask a security company to come in and install cameras, alarms, security beams, and an electric fence.
2. They send a consultant to assess your security system, and he puts a solution together for you.
3. You sign off on it, and a team arrives and installs it.
4. You then sign off on a 12 month contract for armed response with that security company – which includes a neighbourhood patrol, and a night guard on long weekends.
5. Two weeks later, while you are away for a long weekend, your house is robbed.
6. You immediately blame:
7. 1. The consultant for designing a bad system;
   2. The installation team for the way they configured it;
   3. The armed response call centre for not reacting fast enough;
   4. The neighbourhood patrol for not being vigilant; and
   5. The night guard for sleeping on the job.
8. The security company defends itself by pointing out that it runs the same system in every house in your neighbourhood – and that the level of crime has dropped dramatically since they started.
9. They investigate the theft themselves, and ascertain that the thieves were very sophisticated:
10. 1. They had bribed one of the installation team to give them some of the plans to the security system.
    2. They’d acquired signal jammers to block your remote-activated sensors before you left the house for the weekend.
    3. They had observed the night guard’s habits for two nights prior to the break-in, and worked out when he would normally take a toilet break.
    4. The security cameras show that the theft took place within a thin window of time – meaning that there was clearly an inside job, because the criminals knew exactly where the safe was.
11. You are outraged by the bribed employee at the security company, but reject the rest of their findings as flawed and self-serving excuses.
12. You sue the security company, while gathering signatures from your neighbours in an online petition to have them disbanded.

To be clear, in that story, the security company are a stand-in for the audit firms. And the thieves are white collar criminals.

The infallibility fallacy

Here’s my problem with the current outrage: we have a tendency, as a service-demanding public, to expect services to be infallible.

Only, this is the real world. A real world is not utopian – it has flaws, and systems that fail. And the real world also has criminals* who make it their business to hunt out systemic weaknesses and exploit them.
*criminal, n. a dedicated and hardworking entrepreneur, flawed by a lack of scruples.

Also, importantly, the real world is constantly evolving.

So even if you could design a system that was 100% invulnerable to every known burglar trick in the book – over time, criminals would invent new tricks with new technology.

The point is: we simply cannot expect zero crime and zero mistakes – we can only try to minimise them.

Which is the reason that we have audit firms in the first place.

And that last part is the reason that I don’t want to end here.

PART 2: CAPITALISM AND AUDITING, A CO-DEPENDENCE STORY

[Disclaimer: telling the larger story involves some accounting history, so please bear with me.]

I’m going to start with a question.

What is “accounting” anyway?

For my entire adult life, I have been either an accounting student, an accounting academic or an accounting professional – and I still don’t have an easy answer to this question. Here is wikipedia:

Even my eyes glaze over reading that. It may be descriptive, but it’s not helpful.

Google offers this:

Which is basically a version of: “Accounting means accounting”. Also unhelpful.

So let me give you an alternative – one that is (hopefully) more helpful:

Accounting, n. a method of keeping score. For some, it is a measure of how much purchasing power they have confiscated from their customer. For others, it is a measure of how successfully they have withheld their profits from the tax man. And for everyone, it is a measure of how well they are outperforming the other players in the commercial game.

Unfortunately, we are used to team sports, with clear referees, goal posts, pitches and acceptable behaviours. Commerce is not that kind of game:

• The playing field is not solid ground. Rather think of it as a wavy expanse of sea water, outlined in chalk.
• The main referees make up the rules as they go along. And they’re appointed and removed by the players, at semi-regular intervals.
• Everyone is inclined to cheat, wherever they can.
• The game never ends.

And in this complex and dynamic competition, accountants are the scorekeepers.

A brief history of the Modern Commerce Game: the rise of the limited liability company

Double-entry accounting has existed since the 1300s – but “accountancy” as a profession only truly came into existence when “limited liability” was invented. And this is something that tends to be overlooked: without limited liability companies, capitalism would not exist.

If you look back at the time before limited liability companies, there was no way to separate your personal life from your work life. If you wanted to build a business, or invest in a shipping venture, you were on the line for everything. Not only could you lose the family home, you could have yourself thrown into debtor’s prison, and your children packed off to the workhouse.

In the West, the revolutionary idea of the 16th century was to separate the business into its own separate legal entity. By the 1800s, the businessman-owner had the option to incorporate. He would no longer be enslaved when his business failed – creditors could only chase the business for the recovery of their debts. Limited liability was the birth of capitalism; and with this liberation of risk, the world of business exploded into the Industrial Revolution.

More commerce meant more legal disputes, more taxes, and more regulation. Bodies of legislation and case law began to develop around these new companies. Ownership was exchanged in joint-stock companies, and public share registers had to be maintained. If the liabilities were kept separate, then you also had to separate out assets and profits and streams of cash flow.

Capitalism may be a system built on the ownership of capital, then that ownership has to be demonstrated with historical records.

And professional accountants kept them.

A brief history of the Modern Commerce Game Part 2: Financial Crisis, and the rise of the auditor

Limited liability companies freed entrepreneurs from the threat of debtor’s prison, and borrowing money became widespread. But with all this new debt and money floating around, the world inevitably began to undergo financial crises.

Whenever those would happen, new laws and regulations would be crafted to try and prevent them from happening again. People realised that the growth in credit was great for economic growth and technological progress – but the cost was periods of economic instability, and credit crunches caused by over-borrowing.

To limit those impacts, some accountants were asked to take on the legal responsibility for checking the accounting records for accuracy, so that the providers of credit could have comfort in their lending decisions*.
*other people (like shareholders) and institutions (like tax collectors) were also interested – but I’m trying to provide gist rather than exacting detail.

And thus, auditors were invented.

Accountants v Auditors

So what marks a particular accountant out as an auditor?

Well, this is where we might start talking about accounting being the “language of business”. Accountants are trained to articulate business in a way that is meaningful.

And auditors specialise further, and become editors.

They take the business-story that other accountants have produced, and check it for coherence, consistency, and correct forms of expression. They also try to make sure that the story is as non-fictional as possible.

I drew a picture:

You might call this the Capitalist Ecosystem. Lenders of capital want records. Borrowers of capital need accountants to prepare those records, and then auditors to verify them. And thus, capital can flow.

In many ways, auditing is to capitalism what indoor plumbing is to modern homes. It’s essential, but hidden.

And it’s only when it fails that you notice it.

PART 3: WHERE IT GOES WRONG

In this story, accountants began as record-keepers. But as corporate law expanded, the role of the “auditor-accountant” became regulatory. Essentially, instead of the State attempting to enforce accurate record-keeping itself – it outsourced that task to a group of people who were already well-versed in the language of business.

And because auditors are regulators, they are susceptible to all the normal failings:

• Being bad at their job – where the auditor is simply not skilled enough (or up to date enough) to do their job effectively;
• Being lazy – where the auditor can’t be bothered;
• Not doing a good job on purpose #regulatorycapture – where the private sector corrupts an auditor;
• Being lied to – where they’re being openly defrauded; and
• Conflicts of interest – where economic circumstances, or State actors, weaken their regulator powers.

All professional bodies of accountants (SAICA included) are particularly committed to combatting the first three. After all, their ongoing existence as a profession is dependent on them doing so. Candidate auditors face board exams and training contracts to qualify. The auditing firms are subject to quality control audits of their audits. There is lots of paperwork, and continuing professional development, and all those good things.

But despite all that, the profession is still made up of people. And people are the most fallible part of the equation.

So you will still get incompetent auditors creeping up through the ranks, even though they pass the exams. You will still get lazy auditors, who falsify their audit work in order to go home early. And you will still get corrupt auditors who allow themselves to deliver opinions that get them reappointed, or get them hired elsewhere.

And importantly: auditors can still be deceived, and their effectiveness can still be weakened by external forces.

Which brings us circling back to the point about utopias. We don’t live in one. Instead, we try to minimise the level of failings – but we can’t stop all of them.

And sometimes, we create situations that temporarily increase the potential for failure.

PART 4: A SOUTH AFRICAN END NOTE

Over the last decade, South Africa’s audit firms have been dealing with the impact of a new Companies Act (which came into effect in May 2011).

A Companies Act of Fewer Audits

Here is what you need to know about the new Companies Act and its impact on the audit profession:

1. The original one (from 1973) legally required all companies to be audited.
2. The new one only requires audits for public companies, and large private companies with ‘economic impact’. The rest of them just need an independent review of their financials.
3. To give you some perspective on that:
4. 1. In 2017, there were almost 3.8 million companies that were registered with SARS.
   2. Of those, only 24% were expected to submit tax returns.
   3. And only about 32,000 companies (0.8%) were expected to make more than R1 million in pre-tax income.
5. So from an overall economic perspective, imposing audits on every single one of those 3.8 million companies is madness.
6. But doing away with the audit requirement did mean that the audit profession as a whole was losing a chunk of its economic activity.
7. And this impact was something of a ripple effect:
8. 1. The Big 4 audit firms, and a few of the other large ones, were auditing large companies – so they were not as immediately affected.
   2. But the small and medium-sized audit firms suddenly found themselves without a bunch of clients.
   3. From what I can tell, those smaller firms went in one of two directions:
   4. 1. Some down-sized, and specialised in becoming tax practitioners, and doing those independent reviews.
      2. But there was also a wave of mergers that allowed those audit firms to compete for some of the remaining audit work.
   5. That then placed upward pressure on the larger audit firms, who were losing ground to some of their cheaper-but-now-larger competitors.
   6. Some of the larger audit firms followed suit (like the Grant Thornton and BDO merger/takeover/partnering).
   7. This placed some pressure on the Big 4.
9. Either way, this jostling for clients in the audit world was probably best for clients, who now had some scope to negotiate much better audit fees at all levels.
10. And the audit profession as a whole now faced a new reality:
11. 1. Fewer full-audit clients; and
    2. Less revenues.

Lower revenues means more cost-cutting, fewer bonuses and smaller salary increases. Paying professionals less is not good for staff retention – because auditors can find alternative employment outside of the audit profession, they leave. And thus, the audit firms have access to a diminishing pool of talent.

And given that, is it really all that surprising that the quality of the audit work might go through a bit of a decline?

Unfortunately, this is an adjustment phase.

And these scandals are a part of bringing it back into balance.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.