Financial Cryptography

Lords: Auditors guilty of 'dereliction of duty'

I had thought I was a voice in the wilderness on the question of criticising Audit as having left the party by the back door before the cops arrived. But, no, it seems that some have noticed. The Economist reports:

THE average divorce in Britain comes after 11 years of marriage. Compare that with the fidelity of a big British company to its auditors: 48 years on average, according to the Financial Reporting Council, Britain’s accounting watchdog, which tallied the figures for Britain’s biggest firms, the constituents of the FTSE 100. The reason is increasingly obvious, and worrisome, to regulators in Britain and elsewhere: the concentration of big accounting engagements in just four firms’ hands: PwC, Deloitte, KPMG and Ernst & Young.

The “Big Four” audit 99 of the FTSE 100, and 240 of the FTSE 250. ...

OK, that's really a follow-on from the Arthur Anderson and KPMG story of too big to fail. Yes, the Audit industry is now totally concentrated, which indicates to the economists amongst us that fees will have risen and the product will have drifted. Note that I didn't say quality, as in some cases the quality might have gone up -- including to well beyond reasonable, where we are paying for something we don't get a benefit from.

Which point I made in that Audit cycle; Auditors no longer serve society, society serves Auditors. Which came to a head with the financial crisis of 2007:

This caught the attention of the House of Lords, which in March pinned the firms’ “dereliction of duty” in the financial crisis, in part, on their oligopoly. (To make matters worse, only three of the four audit banks in Britain.) The Lords recommended that the Office of Fair Trading take a look at the problem. On May 17th the OFT announced that it was opening formal investigations into whether to refer the issue onto the Competition Commission, which could force changes on the industry.

So an investigation is being opened. This is one of those sticky areas where the Auditors police themselves, so what happens when that fails? Who do you go to? Well, the answers are somewhere between nobody and everyone. In this case, everyone includes the Lords, the OFT and the Competition Commission.

Which brings up the next sticky point. Are we really saying that this is a competition issue?

The firms insist that removing experienced audit firms from their clients would be inefficient and expensive. But regulators will weigh that potential expense against the expense of another systemic “dereliction of duty” by the auditors. The disappearance of one of the Big Four—recalling how quickly Arthur Andersen evaporated in the Enron scandal—would be more expensive still.

Apparently we are at least weighing competition issues with the systemic problem of the collapse of 2007. I don't know quite how the Economist came to that conclusion, but to me, the big question is this: how did the Auditors completely miss that all the big firms in Wall Street were about to cross into bankrupcy (declared or otherwise)? As the UK parliament summarised this question:

‘The breakdown of dialogue between bank auditors and regulators made the financial crisis worse’

Auditors were either unaware of the mounting dangers in the banks or, if they were aware, failed to alert the supervisory authority. The paucity of meetings between bank auditors and the supervisor was a “dereliction of duty” by both auditors and regulators. The Committee recommends legislation to re-establish mandatory two-way confidential dialogue between bank auditors and supervisors to help avoid a similar crisis in future.

Here's one suggestion of an answer:

...the UK House of Lords’ Economic Committee [...] recently asked UK leaders of all of the Big 4 audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – about the absence of warnings or “going concern” qualification for banks that failed or were bailed out.

The auditors’ response: The Bank of England told us, in confidence, that they would support the banks financially.

That's a really interesting answer! But I for one am not ready to call that a *good answer*. And if we don't have a good answer to that question, do we have a need for a good Audit?

ICAEW chief executive Michael Izza rejected the argument that auditors were culpable in the banking crisis, stating: “They did the job that they were expected to do - provide an audit opinion on banks' financial statements.”

But that isn't it! Audit has shifted from "opinion over financial statements" to being a small cog in a huge consulting machine. So we seem to be getting to the nub of the question: can the Auditors have their cake and eat it to?

This is a question that is slowly being asked. Amongst leading cases against audit is this:

Cuomo’s final act as NYAG last [December] was suing Ernst & Young for fraud for allowing Lehman Brothers to cook its books using “Repo 105.” That accounting practice, which may have been used by other Wall Street firms during the subprime binge, allowed Lehman to take billions of its toxic assets off its balance sheet for a few days at the end of the crucial 2nd and 3rd quarters of 2008, months before it filed for bankruptcy.

By moving toxic assets first off and then back on its books, Lehman was effectively dressing up its balance sheet in a deceptive manner. The lawsuit essentially alleges that Ernst & Young was aware of the practice, starting when it became Lehman Bros.’ auditor in 2001 until the firm’s death in 2008.

Lehman Bros.’ actions, and Ernst & Young turning a blind eye to them, stink to high heaven. Investors suffered devastating losses from the accounting chicanery. But one, huge question remains unanswered: As the financial and subprime crisis unfolded, where were the auditors who were the “gatekeepers” charged with protecting shareholders?

Or, more on point to whether Auditors do indeed provide an audit opinion, the Lehman Brothers bankrupcy report said:

(3) Ernst & Young Would Not Opine on the Materiality of Lehman’s Repo 105 Usage

Don't hold your breath that Auditors will be brought to account before the judge, though.

"Every time somebody comes up with a new fraudulent scheme, auditors miss it," said Andrea Kim, a partner at law firm Diamond McCarthy LLP in Houston who represents plaintiffs in auditor lawsuits. "The historical pattern is that they find a way to manage the litigation to limit their liability."

The credit crisis, which pushed the U.S. financial system to the brink of collapse, led to a wave of investor litigation against banks, lenders and others. Auditors are prime targets because investors try to rope in as many defendants as possible to increase recoveries. Auditors also may have the deepest pockets if the company they audited files for bankruptcy.

So we are now seeing a big lesson unfold. So far the Auditors are securing many dismissals and some settlements. The lesson then is more for us than them.

Posted by iang at May 24, 2011 04:37 AM | TrackBack