So, you want radical economic transformation? Breaking up the auditing cartel is a good place to start President Zuma…

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By Khaya Sithole

zuma-sona3In 1915, General Louis Botha led the invasion of Namibia. Beyers Naude was born and James Hertzog established the national party’s propaganda machine – Naspers. In 1915, PricewaterhouseCoopers (PwC) started auditing Naspers.

In 2017 the South African Constitution turned 21 years old. President Jacob Zuma called for South Africa to implement radical economic transformation. Naspers turned 102 years old. PwC celebrated the 102-year anniversary of its audit relationship with Naspers.

The President’s 2017 State of the Nation Address was memorable – mostly for the wrong reasons. The core message of the President’s address was the call for radical economic transformation. It is quite possible that not a single person in the National Assembly knew what exactly that meant.

The problem with the idea of radical economic transformation is that quite simply no one knows where to start and what exactly needs to be transformed or what the precise meaning of radical is. To fully unpack the president’s wish list, it is perhaps important to trace the ANC’s bizarre journey towards finding its locus point on matters of economic freedom.

Back in 1991, the ANC commissioned the Macro-Economic Research Group (MERG) whose only role was to define what the ANC’s approach to running the economy of South Africa ought to be. MERG then produced the ANC’s 1993 economic blueprint called ‘Making democracy work’. In its essence, the blueprint articulated that the economy required restructuring through the following interventions – improved training, skills and development; the raising of wages and state intervention to improve the structure and operation of the private sector.

MERG calculated that the sum of its proposed interventions could boost economic growth to 5% and create more than 300 000 jobs per year. Naturally, the business community, led by Anglo American, attacked the report as absolute rubbish but it somehow survived and was used as the basis for creating the Reconstruction and Development Programme (RDP).

To understand the ANC’s paralysis in economic matters you’d have to remember that when the ANC took charge of the state in 1994, it decided that – in order to maintain internal white business confidence and international business confidence alongside currency stability; the Ministry of Finance should remain in the hands of the National Party and that the Broederbond Governor of the Reserve Bank – Chris Stals – should remain in his position. MERG’s proposals therefore were essentially subject to implementation by the National Party arm of government – and naturally, they were not implemented.
Thabo Mbeki Photo: Eric Miller/World Economic Forum 2008
Luckily for the opponents of RDP, Thabo Mbeki took charge of the economic cluster in 1996 and Trevor Manuel was elected as the Finance Minister. Their first task was to abandon the ANC’s own economic blueprint by rapidly dismantling MERG’s RDP and replacing it with GEAR. This essentially formalised the ANC’s breakaway from the economic ideals it had crystallised in the Freedom Charter in 1955.

In order to sell GEAR to the ANC, Manuel and Mbeki fabricated some economic projections that could never be achieved. For example, GEAR projected growth rates of 6% plus and 400 000 new jobs being created every year. The reality of GEAR is that it abandoned the ideals of fundamental economic restructuring in favour of elevating the status of those already within the economy. In attempting to elevate the middle class, GEAR failed to create new points of entry for those historically excluded from the economy.

This means that the black middle class that Mbeki is credited with elevating is nothing more than an insignificant proportion of the population whose economic impact is rapidly fading.

The Zuma desire to implement radical economic transformation is therefore a desperate quest to reverse the negative and obviously disastrous impacts of the neo-liberalism adopted by Trevor Manuel and Thabo Mbeki. The problem however, is that we all suspect that Jacob Zuma has absolutely no idea what he needs to do in order to achieve this – and this will cost the ANC an election one of these days. So perhaps we should try and provide some direction to the prince of Nkandla.

An inclusive economy?
South Africa’s key economic problem is the inability to implement a sustainable inclusive economy. Several industries and sectors are dominated by a few players whose ability to dictate the terms of the market make it impossible for the democratic dividend to cascade to the majority of South Africans.

The most practical way to implement radical transformation within this economy is to break up the cartels that continue to dictate the economic direction of the country. The 5 biggest cartels that are crippling the country are in banking, construction, healthcare, mining and the auditing profession.

Last year, I wrote about the bizarre case involving Netcare, KPMG and the Competition Commission.

The essence of the case is that the ANC’s only ambitious policy proposal since 1994 – the National Health Insurance scheme – has been paralysed not just by Aaron Motsoaledi’s inability to explain exactly what he does for a living, but also by the impact of the economic design that Thabo and Trevor dragged us into.

At the heart of the case are 2 of the most dangerous cartels in South Africa – the healthcare industry and the auditing profession. In order to implement the National Health Insurance, the state needs to understand the healthcare system and its value chain. To this end, the Competition Commission undertook to conduct an inquiry into the sector. The 3 main players in the cartel known as the healthcare sector – Mediclinic, Life Healthcare and Netcare – naturally opposed this process. The Competition Commission issued a tender for professional services firms to conduct the inquiry on its behalf. KPMG won the tender in 2013.

Then the healthcare cartel decided that the process needed to be delayed. It turned out that KPMG had been the auditors of Netcare. Netcare then sued the Commission and KPMG and stated that KPMG should not be allowed to assist the Commission fix the healthcare industry as this might harm Netcare’s ability to profit from the market. This meant that the Commission had to delay its work as it was dragged through the courts by Netcare. Its deadline for completing the inquiry was December 2015. It is now February 2017, and the inquiry is not even halfway through.

The industry
At the core of the problem is that the auditing field is nothing more than an old boys club run by 4 firms who control 96% of the marketplace. They tend to hold on to their clients forever. The problem is that the expertise around certain industries then exists within the big 4 firms. For the Competition Commission though, the problem was that KPMG’s expertise could not be matched by anyone else on the market and cancelling the KPMG contract would result in the indefinite delay of the Commission’s work and the National Health Insurance Scheme would never see the light of day. The issue of 4 players owning 96% of the market is therefore a massive scandal of market concentration and needs to be urgently addressed.

During 2016, the Independent Regulatory Board for Auditors (IRBA) initiated a process of soliciting public comment regarding the possible implementation of Mandatory Audit Firm Rotation from 2023. At the heart of the IRBA’s proposal, is the need to firstly strengthen auditor independence and then critically – address market concentration and the stagnant transformation of the audit and related services industry.

The regulator
The Independent Regulatory Board for Auditors (IRBA) is the agency licensed by an Act of Parliament (Auditing Profession Act, 2005) to regulate the auditing profession. Included in the IRBA mandate is the need to ‘take steps [IRBA] considers necessary to protect the public in their dealings with registered auditors’ (at 4(1)(b)) and ‘take any measures it considers necessary for the proper performance and exercise of its functions or duties…’ (at 4(2)(d)).
As an entity created through an Act of Parliament, ‘the regulatory board is subject to the Constitution of the Republic and the law – specifically, the Public Finance Management Act’.

As part of its duties, the IRBA initiated a process of implementing Mandatory Audit Firm Rotation from 2023. The process is aimed at addressing 3 features of the auditing profession that the IRBA regards as ripe for corrective regulatory intervention – auditor independence, market concentration and transformation.

The case for auditor independence
The unique feature of the South African market is that the big 4 auditing firms – Deloitte, EY, KPMG and PwC – control 96% of the listed market.

In other words, 96% of the listed entities are audited by just 4 market players. The listed market space represents the most lucrative source of business for the auditing market. The key issue however, is the reality that most of the relationships between the big 4 and their clients have existed for decades on end and it is becoming increasingly difficult to argue that such firms remain sufficiently independent from their clients.

Economic regulation across the world has been in sharp focus since the financial crisis. The essence of economic regulation in a rapidly evolving marketplace is to anticipate patterns that might lead to market failure and then put in place measures to address such patterns. This is especially so in a sector/industry that has a significant level of public interest. The ability to regulate the profession that serves 96% of the listed companies in South Africa is clearly in the public interest.

The market concentration inherent in the audit market is a legacy of the historic architecture of the South African economy. It is therefore necessary to consider ways of addressing this imbalance through legislative interventions. Regulation is a necessary and valuable tool against imperfect market forces.

The South African auditing market is the very definition of market imperfection. It is therefore disturbing to witness how an entire industry has decided that it would rather bully the regulator rather than find a way to operate within the ambit of rules created to regulate the market and make it more responsive to the South African context. The arrogance of the auditing profession in seeking to destroy the reforms initiated by the CEO of IRBA – Bernard Agulhas – is the most explicit case of the tendency of old boys’ clubs to continue running and dictating significant parts of our economy.

This nonsense needs to end.

The regulator – just like other oversight bodies created through Parliament, exist primarily for protecting the public interest. Once we lose the ability to acknowledge the critical role played by regulators in protecting the public – we will be on the pathway to banana republic status. You’d think that the audit firms would understand the role of regulation in imperfect markets. Apparently they don’t.

The longest audit relationship in South Africa currently is the 102-year relationship between Naspers and PwC. Such a relationship is unlikely to pass the test for independence and objectivity due to its tenure. The most vocal opponent of the audit rotation idea has been an executive from Naspers. It is obviously a uniquely South African reality that the one entity whose entire existence was based on promoting propaganda for an illegitimate apartheid regime has suddenly decided to lecture us on matters of social governance. No other country would tolerate this nonsense.

The passing of Mandatory Audit Firm Rotation would also put South Africa on par with the other 4 members of BRICS. In China, state-owned entities and financial institutions are subject to a 5-year rotation rule. In Brazil, listed companies (non-bank) are subject to a 5-year rotation and companies with audit committees are subject to a 10-year rotation. In India, banks are subject to a four-year rotation and public sector entities are subject to a 4/5-year rotation. In Russia, banks will be subject to a 5-year rotation. Given that the state’s intentions are to ensure that these become our most important trading partners, it is sensible to replicate the audit rotation system that is already in place in these countries.

A common response from the firms that oppose mandatory rotation is the idea that such an intervention will increase compliance costs and also lead to decline in audit outcomes. The basis for such responses is the fact that in some jurisdictions across the world where rotation has been attempted, these were indeed the trends identified in those markets. It is however important to note that the same firms that are opposing the idea in South Africa had the same objections across all the other markets that are cited as exhibits of the ineffectiveness of audit rotation. The need to intervene in the South African market is impossible to deny for a couple of reasons.

The idea that audit rotation would increase compliance costs is rather self-serving. The operational ethos of the big 4 firms is that they are set up as private partnerships whose finances are completely confidential. It is therefore impossible to objectively assess whether the theory that compliance costs would be prohibitive is valid.

Strangely, the most fundamental economic analysis would indicate that a more competitive marketplace is likely to lower costs rather than increase them. Additionally, since the rotation would happen once in a decade, the affected stakeholders would have more than sufficient time to allocate resources towards a rotation process. The idea that such rotations would bankrupt clients is quite simply absurd.

Currently none of the firms outside the big 4 have the ability to break the market hold enjoyed by the big 4. In the absence of new entrants in the JSE listed space, the hegemony of the big 4 will not be interrupted as they are guaranteed to retain their listed clients for ever. The market design is inherently anti-competitive and this paralyses the ability of the medium and small firms to grow to any significant scale. In reality, we should be asking the Competition Commission to probe this industry as soon as it completes an investigation into the healthcare sector!

The transformation imperative
Perhaps the most commendable aspect of the IRBA proposal is the idea that audit rotation will facilitate the transformation of the industry. In rejecting this proposition, the audit industry posits that transformation initiatives already underway are sufficient for the industry. Interestingly, the spokespersons tasked with rejecting the transformation conversation that IRBA wants to introduce are the black CEOs within the audit firms. (Don’t laugh).

The primary feeder into the auditing profession is the South African Institute of Chartered Accountants. Essentially, the institute oversees the provision of the academic pathway required by those who wish to practice as auditors. The transformation picture of the industry is rather disappointing. In 1998, the Institute set itself a target of 3 000 black members by 2005. This target was missed by 9 years and was eventually reached in April 2014.

As it stands today, the membership of 41 485 has only 4 516 black members (10,89%). Perhaps most disturbingly, in the audits of listed companies, the analysis of the 350 partners that sign off on the major audits revealed that only 9 black partners made the cut. That is just over 2%. On the other hand, 255 of the 350 (73%) partners signing off these audits are white.

The profession bizarrely alleges that transformation is happening naturally in the industry. As a result, the industry is therefore advocating for self-regulation in these matters. Unfortunately, self-regulation in light of these numbers would mean that we would need to wait a few decades for the industry to reach the transformation balance it requires. If mandatory rotation was in place, it would be possible to facilitate the entry of more black partners in the ownership and control of the major audits.

Additionally, in the pursuit of self-regulation, the industry undertook to write its own empowerment charter. Unfortunately, this collapsed last year as no agreement could be reached between the big 4 and the smaller players regarding the empowerment issues and the current market concentration. The role of IRBA is to regulate and the role of the firms is to operate within the regulatory framework set by IRBA. It therefore falls upon the regulator to intervene and correct the marketplace. And mandatory audit rotation is by far the most practical way to achieve this.

The profession of contradictions
The most acute contradiction in the auditing industry is the fact that the profession is regarded as the best in the world – and yet the state of South Africa’s public finances is shameful. Most people do not understand how such a contradiction exists. Well, think about it. The public finance sector would be much better off if the management of public finances was incorporated into the teaching syllabus. This would mean that South African students learn about managing their own country’s finances before they master the art of preparing international financial statements. You would think that promoting the incorporation of local government and municipal finance into the syllabus would be a chief priority of the institute – and you would be wrong.

The reality of the current system is that public finances are not regarded as an important to the firms and their associates. The reason is that whenever public finances are in shambles, it is the taxpayer who suffers. And then it gets worse.

After listed clients, the biggest source of revenue for the audit firms is the public sector where they are marshalled in as consultants on an annual basis – in exchange for billions in fees. If public sector financial management was a core component of the syllabus, a much greater number of candidates would be able to migrate into the public sector and fix the country’s finances. But this would kill off a significant source of revenue for the audit firms. So the institute finds a way to argue that the syllabus cannot accommodate public sector issues. Don’t be surprised though. When public finances go wrong – it is the taxpayer who suffers. The institute that we expect to promote public sector accounting in university academic programmes has an interesting tax status. It refuses to pay income tax. Yep – not a single cent. And that is the essence of the South African contradiction.

That institute now seeks to dictate to the regulator how it should be regulated.

The idea that the firms should write the rules will paralyse the regulator and invite the sort of legislative anarchy the country does not need. It is especially disturbing to realise that the organisation that is advocating for self-regulation is a private members-only club that is 73% white and refuses to pay income tax in South Africa.

IRBA on the other hand, is an entity granted the power to regulate the industry by the democratic Parliament that we voted into power.

Correcting biased markets and cartels is essentially the first step in facilitating radical economic transformation. But if the profession has its ways and completely undermines the regulator, Naspers will be audited by PwC for another 102 years.

The state has the power to stop this madness. And this power should be used in order to implement radical changes that result in an economic system that includes the most marginalised members of society.

Let me know when you are ready to discuss healthcare and the banks Msholozi. Meanwhile, I have a petition to submit to the Competition Commission.

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