May 24, 2011

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

In the wake of Enron, congress passed SOX that was supposedly to prevent a repeat of Enron and enormously increased audit requirements. However, for SOX to actually have any meaning (other than large gift for the audit industry), it required regulatory agencies like SEC to do something. Note that SOX also required SEC to do something about the rating agencies (implicated in recent financial mess with estimated $27T ... that's like ten to the twelfth ... in triple-A rated toxic CDO transactions during the period).

However, a repeated theme in the Madoff hearings, SEC was doing little during the period. The person that testified they tried for a decade to get SEC to do something about Madoff, also mentioned that tips (whistle blowers) turn up 13 times more fraud than audits.

In the middle of the last decade, I was at a financial conference in Europe ... with CEOs of European companies and presidents of European exchanges ... and the major discussion was that SOX audit burden was starting to leak into Europe (I took position that the possibly the only provision that might make a difference was the whistle blower section ... this was well before the Madoff hearings; but was seen for it to be effective, it required action by regulatory agencies).

However, apparently because (even) GAO didn't believe that SEC was doing anything during the last decade, GAO started doing reports showing uptic in public company fraudulent financial filings (even with the enormously increased SOX audit burden). From recent quote on the web: "Enron was a dry run and it worked so well it has become institutionalized".

Posted by: Lynn Wheeler at May 28, 2011 01:53 PM

tv business news shows past week or so have had periodic rants against SEC issuing guidelines on whistle blower provisions (nearly a decade after whistle blower section showed up in SOX) ... seemingly much stronger opposition than the rants against SOX audit provisions;

since SOX audit provisions actually cost quite a bit more than whistle blowers ... could the rants against whistle blowers be because they actually turn up 13 times more fraud (than audits; not because they cost significantly less).

Posted by: Lynn Wheeler at May 28, 2011 03:22 PM

Jim HOrst writes:

By the way, we all know there is no such thing as "independence" in the external financial audit (attest) function in the US. Based on current system, there can't be. What we have is a system where those in charge of financial reporting and those responsible for auditing have written the rules to benefit themselves, rather than the investing public. (See this BusinessWeek interview with Arthur Levitt, former SEC chairman, and this excerpt from his book, "Take on the Street.")

Wouldn't it be laughable if the Chicago Cubs hand picked their own umpires for each game, paid them directly, went out to lunch with them, and paid them for other work unrelated to baseball? Would the other teams think this fair? Of course not. Why? Because such actions would surely compromise the independence of the umpires.
How could they call balls, strikes and plays fairly?

Yet, look at how CPA firms operate with companies they audit. The company hand picks them, pays the CPAs a fee directly, chums around and plays golf with them, and the CPAs do other unrelated work for additional fees. ....

Posted by: Jim Horsch on "No such thing as Independence..." at May 31, 2011 05:14 AM
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