Comments: Audits VII: the future of the Audit is in your hands

I've mentioned several times being at a european ceo/executive financial & exchange conference several years ago and in session on spreading issues with sarbanes-oxley ... that the audits just catch mistakes ... it has no way of catching determined fraud (at least the audit part, there is the whistle-blower section in the bill).

One of the suggestions was verify financial transaction claims in any corporation audit ... against corresponding information in other corporation audits (independent verification of the information). The claim was that the current public company audit infrastructure has no mechanism to implement such a thing ... since each individual company pays for the auditing of just their books (no verification against independent sources).

part of this is motto "trust, but verify" ... from DTRA (a relative spent a decade at dtra ... in treaty compliance):
http://www.dtra.mil/

Posted by Lynn Wheeler at December 28, 2009 01:53 PM

The "open audit" concept is interesting. I looked at your WebTrust example on your site. While I'm not convinced at this point, I'd like to see a case study of this actually in action for a technical certification. I am hesitant to believe that a financial audit could be open sourced. How do you avoid the pitfall that if someone knows the audit procedures to be performed that they can then bypass them? One of the key audit concepts that you seem to be overlooking is the concept of unpredictability of procedures.

@Lynn: To what extent are you looking for auditors obtain "independent verification of information"?

Standard financial audit practices dictate that high risk financial statement accounts are verified with external sources. For example, cash is validated with independently provided bank statements, and sales and accounts receivable balances are independently confirmed with customers. In addition, the auditor needs to perform an analysis over journal entries to detect irregularities and fraud. Granted, none of these are foolproof methods, but some frauds were not detected because these procedures were not performed. In these cases, the frauds could prevented or detected earlier (i.e., Satyam provided false bank statements and the auditor did not bother to obtain independent statements fro the banks).

Posted by Nick Ehle at December 28, 2009 04:34 PM

the comments were that current paradigm didn't easily promote the independent verification of every audited transaction because

1) possible conflict of interest ... since the auditing agency was being paid for by the organization that it was auditing

2) lots of the information about every transaction was available in audits of other public companies ... but because of the lack of independent audit process ... there was no obvious way of cross-checking all transactions across all audits

There was something analogous in lack of transparency and visibility in other related activities.

1) supposedly the information about illegal naked short sales transactions is available at DTC (or since merged with NSCC, DTCC) ... which DTCC is refusing to release. There are press items about DTCC being sued to make that information available

2) in year ago congressional hearings into the current financial crisis ... one of the critical components in the transactions resulting in the current financial mess were the rating agencies. The claim was that the seeds for that part of the mess was laid in the early 70s when the rating agencies changed from the buyers paying from the ratings to the sellers paying for the ratings (opening things up for conflict of interest).

Disclaimer: some of the (virtual machine based) online timesharing service bureaus from the early 70s quickly moved up the value chain to financial information. One of them is listed as buying the "Pricing Services" division from one of the rating agencies in the period of changing from buyers paying for the ratings to the sellers paying for the ratings. I had interviewed with them in the late 60s and stayed in touch with some of the people over the years.

In the more recent congressional hearings into the Madoff Ponzi scheme ... it was claimed that tips turn up 13 times more fraud than audits ... and that while the SEC didn't have a "tip" phone line ... they did have a 1-800 number for corporations to complain about investigations (some people pointed out that SOX had almost inverted its focus on what turns up the most fraud and what turns up the least fraud ... there is further mismatch when considering the cost of audit vis-a-vis the amount of fraud it turns up)

It was also stated in the Madoff hearings that transparency and visibility was much more important than new legislation.

Disclaimer: somewhat as result of having participated in the x9.59 transaction standard in x9a10 financial standard working group, in the late 90s, we were asked into NSCC (hadn't yet merged with DTC) to look at defining standard that improved security for all trades. Not very far into the effort, the work was suspended; a side-effort of changes for improving the security on all trades would have also significantly improved visibility and transparency ... something which apparently is not part of the trading culture.

Posted by Lynn Wheeler at December 29, 2009 09:52 AM

somewhat related recent post in (linkedin) payment systems:

http://www.garlic.com/~lynn/2009s.html#39 Six Months Later, MasterCard Softens a Controversial PCI Rule

As referred to in the above, the countermeasures and the audits ... are enormously more expensive ... as well as the cost of the activities compared to the benefits.

This also gets into past "naked transaction" metaphor discussions that went on here ... some of my posts archived here:
http://www.garlic.com/~lynn/subintegrity.html#payments

also
https://financialcryptography.com/mt/archives/000745.html
https://financialcryptography.com/mt/archives/000744.html
https://financialcryptography.com/mt/archives/000747.html
https://financialcryptography.com/mt/archives/000749.html

Posted by Lynn Wheeler at December 29, 2009 10:08 AM

oh, the numbers from the Madoff hearings were that audits turn up 4% of the fraud and tips turn up 52% of the fraud (13 times as much). A subtext was that there is a fantastic, enormous cost for something (audits) that show such poor results.

Posted by Lynn Wheeler at December 29, 2009 10:45 AM

Nick,

A case study is surely the next step, see link for a sense of that. We see some sense of this with OpenSSL which has gone through FIPS, and has also spent many years out in the open. The question of whether the FIPS process helped overall in comparison to its open work is not something I've looked at, but someone should. We do know FIPS wasn't clearly only positive, there were problems in engineering the RNG (cough) which were not picked up.

Your pitfall of "someone knows the audit procedures" applies equally well to the closed auditor. Your Satyam case in point: probably false bank statements were provided because they knew the auditor wouldn't check them; try that with an aggressive open audit and they would have no such certainty.

Open auditing is conducted in the gold issuance world. Many of the major digital gold currencies publish their reserves and issuance on a daily basis. As temptation builds up to fix internal problems, those publications became material statements which acted as a break. I'm aware of one case where the statements made became false, and therefore fraudulent. If there had been an ability to go to the next step -- check the metal independently -- then that issuer would have been toast.

So clearly, there are some primary evidence things that are hard to open-audit. Bank statements and metal reserves, perhaps. But, having a statement about them is great evidence for later, and actually these aren't as hard as me might fear, we just need to put our heads together and figure out how to do it.

Posted by Iang (one open audit) at January 2, 2010 06:24 AM
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