Why Independence is Vital in Auditing and the High Costs of Conflict of Interest

What we teach | The Lesson: “Guard against conflicts of interest. Always stay objective and independent of your client.”

Reality Check: PwC – BHS, KPMG – Patent box, and EY – Repo 105.

In the world of auditing, “Independence” stands as a fundamental value.

It emphasises how critical it is to keep impartiality in financial reporting. Independence isn’t a mere formality; it forms the backbone of trust in audits. Auditors are advised to “steer clear of conflicts of interest” to keep their judgments unbiased.

Yet, cases like PwC’s audit of BHS show how easily this principle can falter.

Ernst & Young’s (EY) audit of Lehman Brothers further exemplifies the issue.

KPMG’s involvement with the Patent Box legislation also reveals failures when financial interests and personal relationships get in the way.

Let’s unpack all of the above, one by one.

In 2014, PwC’s work on BHS’s financials drew sharp criticism. Evidence surfaced that the lead auditor had close personal ties to BHS’s finance director. This discovery led to immediate concerns about PwC’s impartiality being compromised.

The situation grew more complicated because PwC was also heavily involved in consulting for Taveta, BHS’s parent company. While PwC’s fee for auditing BHS was £355,000, its consulting fees from Taveta amounted to £2.86 million. This stark imbalance raised questions about PwC’s ability to be truly objective. Such a large share of income came from non-audit work.

PwC was fined £6.5 million by the Financial Reporting Council.

A very similar case emerged in the EY – Lehman Brothers case just before the 2008 financial crisis. 

Lehman Brothers employed a questionable tactic known as “Repo 105”.

This enabled the bank to temporarily move billions in debt off its books. As a result, it presented a more favourable financial condition than was true.

Ernst & Young, as Lehman Brothers’ auditor, approved accounting techniques that helped the firm hide its financial weaknesses.

Later reviews indicated that EY had a long-standing relationship with Lehman. The hefty audit fees it earned may have undermined its independence. This impaired objectivity led to a serious audit failure. This failure contributed to one of the most notorious financial collapses of recent times.

This is another clear case where policy advising and client consulting blurred. It was KPMG’s work in shaping the Patent Box legislation. They then advised on it.

The UK government introduced the Patent Box to incentivise domestic innovation, offering tax breaks on profits from patented products. KPMG’s involvement, however, reflected the classic “poacher turned gatekeeper syndrome.”

First, KPMG consulted with the government on designing the Patent Box to boost innovation and intellectual property in the UK. After the policy was implemented, KPMG changed roles. They began advising private clients on how to best use the Patent Box for tax savings.

Many argued that KPMG’s intimate knowledge of the policy’s details gave it an unfair edge. This advantage helped them identify tax reduction opportunities. It effectively transformed the Patent Box from an innovation driver into a tax-saving tool. Other firms, like Deloitte, Ernst And Young, and PwC, also used ‘insider knowledge’ from the Treasury. They did this to dodge taxes for their clients.

Each example demonstrates how conflicts of interest can arise.

These conflicts can weaken the independence that is critical in auditing. Personal ties can blur the essential separation between audit services and other interests. Imbalanced fee structures and dual roles in policy advising and consulting can also contribute. Such blurring leads to compromised outcomes and weakened trust.

Auditing independence should be one of the most important paradigms. It ensures preciseness in financial statements. It also boosts public confidence in the regulation of capital markets.

That’s all for now, about the third factor of TRIMROT.

When those sworn to guard the gates become the thieves they were meant to ward off, trust halts. In their shadows, dirty money flows like a poisoned river. We shall discuss the fourth factor of ‘Money Laundering’ next time.