Implications of a KPMG Indictment

The number of the Big Four may be changing as the Justice Department considers the penalties for KPMG. The firm may be indicted for allegedly selling tax shelters later deemed to be abusive. The full enforcement of the law could mean a full collapse of the firm; very similar to what happened at Arthur Anderson after it was convicted of obstruction of justice connected with its Enron audits.

“Its an awkward spot,” Jack Ciesielski, publisher of the industry newsletter, the Analyst’s Accounting Observer, told TheStreet.com. There are two sides to an indictment scenario. The firm may avoid heavy punishment from the government which may encourage less than sterling behavior from KPMG or other audit firms in its wake but “if they go ahead and gut it, Im not sure they’ve done anyone any favors,” said Ciesielski.

Top accounting firms numbered five until 2002 when Arthur Anderson collapsed and it was up eight before that. In these times of Sarbanes-Oxley, there is a need for more large accounting firms well able to satisfy the different needs of public companies. The narrowing market doesn’t help a situation in which analysts believe that more completion is necessary.

“People are not focusing on what the real issue is: That you don’t have enough [competition] at the four,” says Lynn Turner, former chief accountant at the Securities and Exchange Commission (SEC) and head of research at proxy advisor Glass Lewis in a statement to TheStreet.com. If the firms get to thinking they are untouchable, what will be the quality of their work going forward?”

After Arthur Andersen was indicted, the number of remaining firms took up the task of auditing for a majority of public companies in the world but it’s a vicious loop. Recent reforms including Sarbanes-Oxley have highlighted the importance of audits designed to expose fraud, while regulators have increased their oversight of the firms performing those audits, increasing the necessity for more complete audits.

On this escalation path, all the accounting firms’ responsibilities have also expanded, making them responsible for evaluating the status of public companies’ checks, balances, and controls intended to internally prevent corporate fraud and then report their findings to the appropriate authorities.

If KPMG is indicted for their alleged violations, they will no longer be able to certify the results of audits, essentially putting the firm out of business, especially after their clients flee to other accounting firms who can certify their audits.

Indicting KPMG or any other Big Four accounting firm would be damaging at best when you consider the consequential loss of accounting relationships and jobs. Many accounting experts do not feel that seeking a criminal indictment is a productive path. Some liken this action as a “nuclear option.”

“I think the nuclear option should be taken off the table completely,” says Jeff Brotman, managing partner of the Ledgewood law firm and a University of Pennsylvania accounting professor in a statement to TheStreet.com. “The [Big Four] firms are too big, and their importance is too profound and affects too many people.”

Many believe that an indictment against KPMG should be avoided, even firms that might take on more business as a result. “One fewer firm reduces the number of choices,” says Cono Fusco, managing partner in charge of strategic relationships at Grant Thornton in a statement to TheStreet.com. “I think we need more choices, not fewer choices.”

A clear alternative to indicting any firm is indicting partners and other employees of firms who are found guilty of illegal actions. “There are plenty of penalties that can be used to make sure these accounting firms—or partners within them—act within the law,” said Charles Mulford, an accounting professor in the School of Management at Georgia Tech in a statement to TheStreet.com. KMPG has been assisting authorities to the fullest extent. They have terminated executives connected with the tax-shelter sales and facilitated policy changes to ensure unethical business practices will not occur again.

Corporate-governance activists have also pushed for the mandatory rotation of audit firm as done in Italy, for example, except that the decreasing number of top accounting firms has made their calls for reform more difficult. Rotation is an additional way to moderate any comfy executive-auditor relationships. Sarbanes-Oxley specifies the rotation of audit partners every five years instead of the audit firm itself.

J.D. Power and Associates reported that last year almost one in every eight public companies employed three or more Big Four accounting firms for audit and non-audit work. Many large public firms have different accounting needs such as auditing, internal financial control testing, acquisition analysis, software work, and tax and valuation work. Smaller firms may not offer the locations (worldwide or domestic), sector expertise, or staff available with the top accounting firms also. The Government Accountability Office concluded in a 2003 report that “the collapse of another member of the Big Four” would create “a serious problem.”

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