If you're a Fortune 500 CEO, you rely on the Big Four. Deloitte, PwC, KPMG, and EY have dominated the accounting space since there was a Big Five, an era that ended with the Andersen Effect from the $63 billion collapse of Enron amid accounting scandal. Arthur Andersen is no more, and five have become four.
Accounting firms have a critical role in verifying the finances of the companies they audit so that those clients can rely on and publish accurate snapshots of their businesses. Lately, a startlingly high number of those audits are filled with errors and other flaws, according to a report released by a congressional watchdog on Monday.
Not coincidentally, that watchdog, the Public Company Accounting Oversight Board, was created by Congress in 2002 as the virtual embodiment of the Andersen Effect. With a mandate of protecting investors and public interest, it looks under the hood at the accounting industry so another Enron can't happen, and what it's found 21 years later is that the audit industry in a "completely unacceptable" state. A whopping third of all audits conducted by U.S. global accounting firms in 2022, including the Big Four, contained errors, according to the report by the PCAOB. That’s up nine percentage points from the 21% error rate in 2021. And make no mistake, as audit reviews go, the 2023 version from the PCAOB was scathing.
This increase in errors may not just be a product of sloppy work by auditors, though: The mistakes have likely been there for years, and are only being uncovered at a higher rate now because they tend to be found during economic instability.
Deloitte, PwC, KPMG, and EY did not respond to Fortune’s requests for comment.
'Completely unacceptable'
For audits conducted by all accounting firms, including those based overseas and unaffiliated with a global network, the rate of mistakes was even higher. Out of all the 710 audits that PCAOB reviewed in 2022, 40% contained errors, up six percentage points from 2021. There was an uptick in failures to execute the “basic audit steps sufficiently,” PCAOB found, such as the use of non-credible data to support the conclusions.
“40% is completely unacceptable,” PCAOB chair Erica Y. Williams said at a Tuesday press conference. “What I like to think about is not what is an acceptable deficiency rate, but what can these firms do to fix this problem and reverse this troubling trend.”
The audit clients that received faulty audits were not disclosed by the PCAOB.
There was a large jump in errors in non-U.S. global auditing firms, with the percentage of flawed audits nearly doubling from 17% to 31% in 2022. According to the report, some firms that did internal analyses attribute the rise in errors to above-average staff turnover, a generally less experienced staff makeup, and the continued impact of the COVID-19 pandemic and remote work.
But at the press conference, Williams said these excuses don’t explain such a high number of errors.
“Some firms have said the ongoing impacts of COVID-19 and the Great Resignation, the War on Talent, could be contributing factors, but we’re three years out from the start of the pandemic and these challenges are no longer new,” Williams said. “Firms really do have a responsibility to meet the challenges head on. Forty percent deficiency rate simply cannot be explained away by the pandemic.”
'We always see an uptick in accounting fraud'
Part of the problem lies with the lack of oversight systems used by the auditing firms, not just employee error, PCAOB wrote. Some firms lack any quality control system, or even a monitoring procedure to check that workers adhere to professional standards in their accounting and auditing, according to the report. And some firms that do have inspection procedures aren’t performing them, the report added.
While turnover rates, remote-work models, and lack of procedure may all be contributing factors to that 40%, it may also be that the economic climate is making it easier to uncover such errors—or making it more difficult to conceal them.
Historically, more cases of fraud have been discovered during economic slowdowns, said Dr. Feng Gu, chair of accounting and law at the University at Buffalo School of Management.
“Every time there is an economic slowdown, whether it's a significant economic recession or some sort of crisis, we always see an uptick in accounting fraud,” Gu said. “Accounting fraud is related to audit failure because auditors didn't catch these mistakes or problems in the first place.”
Mistakes are easier to bury during periods of growth, according to Gu. When the economy is strong and a company is thriving, underlying problems can be obscured with positive reports of growing business. It makes it harder for auditors, and the auditors’ auditors (i.e., the PCAOB), to catch deficiencies. Now, because the economic climate is unstable or at least not in a period of breakneck growth, accounting errors are easier to detect.
What about the fact that the economy has so far repelled the widely predicted recession this year? Gu noted that 2023 has already seen a regional banking crisis, including the historic collapse of Silicon Valley Bank, "And then for almost a year, people have been talking about a looming economic recession.” Echoing the thesis of a "rolling recession," in which the economy as a whole keeps growing but certain sectors experience retraction, Gu said, “There has been some kind of slowdown in some industry sectors, and this is actually a good condition for financial accounting problems to be exposed.”
Williams said that the deficiencies found in 2022 have been trends in PCAOB reviews for a long time, and auditing firms need to identify ways to prevent these recurring errors. She said her organization is trying to stem the problem by shining a light on consistent mistakes through disseminating its findings to the press, potential customers, and investors.
It's clear PCAOB is feeling the Andersen Effect—it doesn't want the Big Four to shrink any further. "Audit quality is moving in the wrong direction," Williams said. "The firms must turn it around."
