Financial Cryptography

Audit redux.2 - and what happened to the missing MF Global client funds?

As we all know by now, MF Global crashed with some many billions of losses, filing for bankrupcy on 31st October. James Turk wonders aloud:

First of all investors should be concerned because everything is so inter-connected today. People call it contagion and this contagion is real because the MF Global bankruptcy is going to have a knock on effect, just like Lehman Brothers had a knock on effect.”

The point being that we know there is a big collapse coming, but we don't know what it will that will trigger it. James is making the broad point that a firm collapsing on the west side of the Atlantic could cause collapse in Europe. But wait, there's more:

So the contagion is the first reason for concern. The second reason for concern is it’s taking so long for them to find this so called missing money, which I find shocking. It’s been three weeks now since the MF Global bankruptcy was declared and they started talking about $600 million of missing funds.

So I’m not too surprised that now they are talking about $1.2 billion of missing customer funds. I think they are just trying to delay the inevitable as to how bad the situation at MF Global really is.

And more! Chris points to an article by Bloomberg / Jonathan Weil:

This week the trustee for the liquidation of its U.S. brokerage unit said as much as $1.2 billion of customer money is missing, maybe more. Those deposits should have been kept segregated from the company’s funds. By all indications, they weren’t.

Jonathan zeroes in on the heart of the matter:

Six months ago the accounting firm PricewaterhouseCoopers LLP said MF Global Holdings Ltd. and its units “maintained, in all material respects, effective internal control over financial reporting as of March 31, 2011.” A lot of people who relied on that opinion lost a ton of money.

So when I asked:

Let's check the record: did any audit since Sarbanes-Oxley pick up any of the problems seen in the last 18 months to do with the financial crisis?

we now know that PricewaterhouseCoopers LLP will not be stepping up to the podium with MF Global! Jonathan echoes some of the questions I asked:

What’s the point of having auditors do reports like this? And are they worth the cost? It’s getting harder to answer those questions in a way the accounting profession would favor.

But now that we have a more cohesive case study to pick through, some clues are emerging:

“Their books are a disaster,” Scott O’Malia, a commissioner at the Commodity Futures Trading Commission, told the Wall Street Journal in an interview two weeks ago. The newspaper also quoted Thomas Peterffy, CEO of Interactive Brokers Group Inc., saying: “I always knew the records were in shambles, but I didn’t know to what extent.” Interactive Brokers backed out of a potential deal to buy MF last month after finding discrepancies in its financial reports.

That's a tough start for PricewaterhouseCoopers LLP. Then:

For fiscal 2007, MF Global paid Pricewaterhouse $17.1 million in audit fees. By fiscal 2011, that had fallen to $10.9 million, even as warning signs about MF’s internal controls were surfacing publicly.

In 2007, MF and one of its executives paid a combined $77 million to settle CFTC allegations of mishandling hedge-fund clients’ accounts, as well as supervisory and record-keeping violations. In 2009, the commission fined MF $10 million for four instances of risk-supervision failures, including one that resulted in $141 million of trading losses on wheat futures. Suffice it to say, Pricewaterhouse should have been on high alert.

On top of that, Pricewaterhouse’s main regulator, the Public Company Accounting Oversight Board, released a nasty report this week on the firm’s audit performance. The agency cited deficiencies in 28 audits, out of 75 that it inspected last year. The tally included 13 clients where the board said the firm had botched its internal-control audits. The report didn’t name the companies. One of them could have been MF, for all we know.

In a response letter to the board, Pricewaterhouse’s U.S. chairman, Bob Moritz, and the head of its U.S. audit practice, Tim Ryan, said the firm is taking steps to improve its audit quality.

Ha! Jonathan asks the pointed question:

The point of having a report by an independent auditor is to assure the public that what a company says is true. Yet if the reports aren’t reliable, they’re worse than worthless, because they sucker the public with false promises. Maybe, just maybe, we should stop requiring them altogether.

Exactly. This was what I was laying out for the reader in my Audit cycle. But I was doing it from observation and logic, not from knowing about any particular episode. One however was expected to follow from the other...

The Audit brand depletes. Certainly time to start asking hard questions. Is there value in using a big 4 auditor? Could a firm get by on a more local operation? Are there better ways?

And, what does a big N auditor do in the new world? Well, here's one suggestion: take the bull by the horns and start laying out the truth! KPMG's new Chairman seems to be keen to add on to last week's revelation with some more:

KPMG International LLP’s global chairman, Michael Andrew, said fraud was evident at Olympus Corp. (7733) and his firm met all legal obligations to pass on information related to Olympus’s 2008 acquisition of Gyrus Group Ltd. before it was replaced as the camera maker’s auditor.

“We were displaced as a result of doing our job,” Andrew told reporters at the Foreign Correspondents’ Club in Hong Kong today. “It’s pretty evident to me there was very, very significant fraud and that a number of parties had been complicit.”

Now, if I was a big N auditor, that's exactly what I'd do. Break the cone of silence and start revealing the dirt. We can't possibly make things any worse for audit, so let's shake things up. Go, Andrew.

Posted by iang at November 28, 2011 03:51 PM | TrackBack