• Do You Believe In Santa? The Auditors And The Sub-Prime Debacle

    By • Nov 6th, 2007 • Category: Pure Content


    “Dear Editor–I am 8 years old.
    “Some of my little friends say there is no Santa Claus.
    “Papa says, ‘If you see it in The Sun, it’s so.’
    “Please tell me the truth, is there a Santa Claus?

    Virginia O’Hanlon
    115 West Ninety-fifth Street

    Virginia, your little friends are wrong. They have been affected by the scepticism of a sceptical age. They do not believe except they see. They think that nothing can be which is not comprehensible by their little minds. All minds, Virginia, whether they be men’s or children’s are little. In this great universe of ours man is a mere insect, an ant, in his intellect, as compared with the boundless world about him, as measured by the intelligence capable of grasping the whole of truth and knowledge.

    Yes, Virginia, there is a Santa Claus.

    Fortunately some of us don’t believe in Santa Claus, or any other fantasy that says men don’t know what havoc they’ll wreak when they get too greedy or willing to look the other way for the sake of a buck.

    As I was writing yesterday’s post about CEOs losing their jobs over sub-prime write offs and wondering why the auditors don’t lose theirs too, Dennis Howlett was penning similar thoughts, albeit with a slightly different focus and additional details.

    I also got a call from a reporter who asked me to explain why I felt the auditors were part of the problem. This reporter stated, “…the problem is not one of internal controls or lack thereof, but of building up portfolios of illiquid assets that were tricky at best to value in the best of times. So is that an auditor issue?”

    Hopefully, my comments will end up somewhere in a column in the paper. In case not, I will summarize them here.

    1)The essence of Sarbanes-Oxley is to validate controls exist to mitigate risk that threatens a company’s ability to meet its business objectives.

    2)By getting into the sub-prime loan business, these banks and investment companies hoped to profit extraordinarily from above average to high risk activities.

    3)The banks, mortgage and investment companies have an obligation to manage risk at all levels by implementing the proper controls to mitigate it, or at least to identify and monitor it so that the level and types of risk being accepted by the company can be properly disclosed to their investors and other stakeholders.

    4)An important part of identifying, monitoring and disclosing these risks is to value them according to GAAP and to the extent a reasonable investor would expect. Another would be to reserve according to GAAP and to the extent that a reasonable investor would expect in the event of a change in economic or other circumstances.

    5)As part of the external audit process, auditors must form an opinion on whether their clients are complying with GAAP (or the other applicable standards) and whether activities such as valuation of the investment portfolio and estimation of required reserves for potential portfolio losses have been properly performed. Does the client have the internal controls in place to assure that valuations and reserve estimates are correct according to accounting standards and provide a fair presentation in the financial statements of the assets and liabilities of the company?

    Add to these obligations, the responsibility of the auditors to ascertain Tone at the Top, that is, whether senior executives have communicated the right tone regarding controls and completeness and validity of financial information so that managers are not afraid to alert them when a strategy or approach is no longer correct or when significant losses are probable or foreseeable.

    In other words, serious financial problems don’t usually happen as suddenly as some companies like to make you think, because of foreign competition or some other boogie man for example. They are building up, slowly but surely, based on a lack of internal controls over managing risk.

    The reporter asked me about the valuation issue. Isn’t it a reasonable excuse to say no one could have seen this train coming? I reminded her that this is one of the quality problems that the Big 4 keep having when the PCAOB comes around. They can’t get it right or don’t think they are doing anything wrong. Unfortunately, the auditors, most of which at the partner level have spent their whole lives being auditors, always one step behind the financial innovators and potential sham artists they are attempting to audit, will always be playing catch up to the masters of the universe.

    is
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    3 Responses »

    1. Of course the auditors should have seen this coming. The problem is: 98% of Big Four partners are economic ignoramuses. I used to work for a then Big Eight firm. These guys want to tick boxes and never get down to the substance of anything. As to SARBOX, etc., that’s all window dressing. The Big Four should never have opined on any company’s financial statements which had material assets valued based on models. They learned nothing from Enron. By the way, I saw the subprime debacle coming. I remember the S&L crisis. I was that coming too. In 1983 Bert Ely went before Congress to testify about the S&L crisis. The “experts” said he was nuts. Who was right? The Big Four, like the rating agencies are part of the problem, not part of the solution.

    2. […] the subprime crisis peaked at the end of in 2007, I wrote this: Fortunately some of us don’t believe in Santa Claus, or any other fantasy that says men don’t […]

    3. […] warned that the CEOs and their Big 4 buddies should be nervous, too.   The Big 4 are now inextricably tied to their clients’ fortunes. Lawsuits are flying fast and furious as soon as any particular situation appears to be […]

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