A few comments…

1) “…plenty of cases where the auditors took a hard line with their clients when they could easily have caved.” Yes, they’re called auditor changes. After SOx was passed, we saw a record number of auditor changes. That trend continued until recently when clients started to regain the upper hand. Clients thought they could just switch when auditors unexpectedly said, “The buck has to stop.” And they did. But another firm was ready to take the engagement, even in the worst situations such as Fannie Mae, for example. There’s a long list of others. And in some cases the auditors quit in order to draw a bright line under their liabilities. In either case, another Big 4 was most often ready to take the engagement, although curiously enough the client usually had to eventually do whatever the first auditor said. It was just a different messenger.

Unfortunately when it came to the banks, mortgage originators, and other large financial services firms, the money was just too big. They kept playing along under the ploy that it would all work out eventually, maybe next year the situation will turn around, maybe the assets will be worth something tomorrow, maybe housing will continue to go up…

2) “…And I don’t think I have ever seen a case where the auditors signed off on something they knew was wrong (although I imagine it sometimes happens).” Oh geez, that’s like shooting fish in a barrel. There are plenty of audit failure cases where the auditors settled. Just because they settled doesn’t mean they weren’t wrong. In fact, to me it does. It says to me they are unwilling to pay to defend their honor and the “professionals just doing a good job within the structure of regulations…” Go to trial, prove that case, and they will be less likely to get sued unnecessarily again. Oh wait, they tried that. BES/BDO Seidman. They did not have the money to settle and had been good at defending themselves before.. Shall I name a few more?

3) As far as the defense that auditors are the best of the rest of the population of frail, short sighted, lazy stupid, self-interested creatures on earth? Sorry, that won’t fly with me. I expect more. They are professionlas with a duty to the public.

4) Last thing. Even the PCAOB, that toothless for the most part, “captured” regulator, had the cojones in December to say the firms were not learning from their errors, were continuing to make the same “mistakes” on the same fundamental principles. And that’s only a sample. Read it and then tell me that the firms are not making a cost benefit decision every time they do “not perfect” things?
http://retheauditors.com/2008/12/pcaob-seeing-the-big-4-through-rose-colored-glasses/
Francine

I’ve audited everything from start-ups to Fortune 10 corporations, so yes, I realize that there are negotiations involved… sometimes (particularly pre-SOX) as blunt as “if you’re not going to qualify the opinion for this, then go away and quit bothering me.”

I’ve also reviewed the workpapers of dozens of other auditors, from firms ranging in size from the Big Four down to one partner. And I’ve seen situations where procedures that I would have thought necessary weren’t performed, or risks weren’t understood, or red flags passed unseen.

HOWEVER, what I mostly saw was professionals trying to do a good job within the structure of regulations and professional standards that has been given to them. I have seen plenty of cases where the auditors took a hard line with their clients when they could easily have caved. And I don’t think I have ever seen a case where the auditors signed off on something they knew was wrong (although I imagine it sometimes happens).

So I agree with you that the audit process is not perfect, as indeed no human process is. And I also believe it could be structurally improved, although the mechanics of doing so are not straightforward or obvious to me.

Where I think I differ from you is that I don’t see any vast conspiracy by auditors to collude with their clients in concealing bad news from an unsuspecting world. Like any other human enterprise, audits may sometimes suffer from shortsightedness, or laziness, or stupidity, or self-interest. The question needs to be whether we are doing all we can to minimize those risks when all we have to work with is a population of creatures (humans) that are so often prone to shortsightedness, laziness, stupidity and self-interest. And to be honest, compared to a lot of the other actors on the political and economic stage, I think the auditors do a pretty decent job of that.

Regards,
AA

Auditors were aware of the deteriorating balance sheets of their clients, especially the financial services companies and industrials like GM and the automotive suppliers for long time. Just look at PwC’s reach and front row seat as auditors of Goldman Sachs and AIG, as well as Freddie Mac, JPM, and Bank of America. How much more of a view from the inside does one need to start recognizing a problem? These are not things that happened suddenly. Instead of a macroeconomic event, there were hundreds of microeconomic events occurring at each of these companies. There was no crisis, only a smoldering heap that burst into flames as the mortgage lenders started to collapse n 2007 and then Lehman and Bear Stearns imploded. Management also knew. The audit process is not the pure , standards based, up in the clouds process you seem to make it. It is a negotiation every step of the way. It is also a broken model that keeps bad news far down the totem pole for way too long or in some cases permanently.

I disagree strongly with Judge Posner’s comments in that decision. I think that’s clear. The outdated, naive interpretation of an auditor’s role based on laws that should have been written to protect shareholders and other stakeholders rather than protect the auditors (PSLRA) and management of public companies is part of the problem. I will cite, as enlightened words, those of Judge Kaplan in the Deloitte Parmalat decision that the case against the international firm and it’s CEO should proceed.

“The willful blindness standard is satisfied where a control person “‘knew or should have known that [the] primary violator . . . was engaged in fraudulent conduct, but . . . did not take steps to prevent the primary violation.’” Here, the Deloitte defendants ask the Court to conclude 101 as a matter of law that DTT’s limited investigation was sufficient. The Court declines to do so.”

Judge Kaplan gets it.

Francine

So your position is that the auditors should have been aware of the credit crisis before it happened, and been better aware of its forthcoming impact on individual companies than the mangagement of the companies it affected, to the extent that the auditors could have proposed an audit adjustment based on hypothetical future events?

I will refer you to your own citation of Judge Posner in the New Century post you cite above:

“The auditor’s responsibility … so far as the company is concerned … is to make sure the [numbers] are accurate…. You don’t need an auditor to tell you your market is collapsing…. The auditors are not supposed to have business insight. They’re counters. They’re not supposed to make predictions about how your markets are doing. They’re supposed to reconcile your books and indicate you’re not a going concern because your debt is too high and so on…. And what is this boxed food business anyway? Auditors are not supposed to know trends in the boxed food business.” (12:15-13:15)

“Do you think the auditor is supposed to know about market power?… An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!…” (17:43-18:07)

I think Judge Posner may overstate the case a bit. Certainly I think an auditor should have views as to how the economic environment affects the values of the assets on the books. And one should expect the auditor to challenge management’s estimates of the value of receivables and inventories, for example, in light of *known* economic circumstances. But if auditors were capable of predicting macroeconomic events with the foresight you seem to be suggesting, we would not be doing what we do for a living and would be making a lot more money.

My comment previously about SAS 99 was alluding to another example where auditors have said to the media and perpetuated the common misperception and expectations gap that they are not responsible for something – in that case finding fraud during the audit. There is clearly a standard that requires them to address this risk.
http://businesstoday.intoday.in/index.php?option=com_content&task=view&issueid=2933&id=12053&Itemid=1&sectionid=35

With regard to the expectation on my part that the audit itself (rather than a separate engagement vis a vis PFI) could identify for the investor risks of future financial failure only has to look at the requirement for the audit to review estimates and reserves for contingencies as a start. In both cases, auditors are expected to review management’s models and the underlying assumptions.
http://retheauditors.com/2008/10/a-question-of-value-why-so-much-ado/

“.. attempting to predict such a thing would have been beyond the auditors’ capabilities, and that they would have been forced to challenge any such prediction by their clients as lacking an objective basis.” I don’t see being dumber than your client a worthy or worthwhile defense.
http://retheauditors.com/2009/04/kpmg-has-a-1-billion-new-century-problem/

Francine

I was not insinuating that write downs are a stab in the dark. What I was suggesting was that to base a write down on a catastrophic future macroeconomic assumption (such as the credit crisis before it occurred) would be a stab in the dark. Francine has made the point that the auditors did not detect the need for write downs in investment portfolios before the crisis was upon us. My point was that attempting to predict such a thing would have been beyond the auditors’ capabilities, and that they would have been forced to challenge any such prediction by their clients as lacking an objective basis.

With respect to PFI, I’m not sure I agree that the auditor is limited to providing negative assurance. My reading of the rules (in the US – I am guessing that you are from the UK and I will admit I’m far less familiar with the professional standards there) is that the auditor may perform an examination engagement to express an opinion about (i) whether the PFI are presented in conformity with AICPA presentation, and (ii) whether the underlying assumptions provide a reasonable basis for management’s forecast or projection (given the hypothetical assumptions), without (iii) providing any assurance that the assumptions themselves are reasonable, although the procedures include evaluating the support for them.

My point on the PFI, however, was that Francine has generally taken the view that the audit itself (rather than a separate engagement vis a vis PFI) should identify for the investor risks of future financial failure. What I was attempting to state was that such an analysis would be prospective in nature, and therefore outside the scope of an audit under professional standards.

As to your second point RE the prospective financial information I am sure you are aware that an auditor can only ever provide negative assurance on such information, which would limit their liability in any case.

I’m not sure how fraud (SAS 99) comes into it – looking forward to your clarification. Being wrong isn’t fraudulent. I agree that if a company represents that the realizable value of its {receivables/loans/whatever} is higher than it subsequently proves to be, *knowing* at the time that it’s untrue, that’s fraud. But being wrong – or even being stupid – doesn’t constitute fraud.

I don’t think I agree with the “sudden” failures argument. Yes, many people I know in the financial sector thought there was a credit bubble before it popped. But no one I talked to expected it to come apart in such a spectacular fashion.

As a practical matter, if a company does have a vague feeling that all is not right in its investment portfolio, how do you translate that into a write-down? How do you translate it into a write-down using sufficiently objective evidence that the auditor can sign off on it? If the failure doesn’t materialize (and it’s very hard to time bubble implosions), at what point do you shrug your shoulders, say “I guess I was wrong,” and reverse your loss estimate into earnings? How do you then justify to your auditors that the reversal into earnings wasn’t “cookie jar accounting” to smooth income? Sure, maybe you can justify increasing your reserves a bit on the basis of some systemic observations, but I think it would have been quite hard to justify increasing reserves to the point they covered what actually happened, if the companies were using models that (incorrectly) predicted everything was going to be fine.

I once performed diligence on a company that had operations in thirteen developing countries. My comment to the investor was that over a five-year investment horizon, I could say with a pretty fair degree of assurance that something would go horribly wrong in at least one of those countries. But I couldn’t begin to guess which, or what the magnitude would be, or how to model it. Trying to account prospectively for systemic market failure would be like that, but worse. How do you even begin to develop an objective estimate of the impact of the biggest financial crisis since the Great Depression, before it happens, that will withstand testing?

Cheers,
AA

Thanks for your comments. I understand what you are saying, but there have been too many “sudden” failures lately to say that there should not have been earlier warnings. Auditors don’t like to be the one who lights the match and incinerates a big fee as well as provokes the liability issues you mentioned. But they already have those downsides if it fails anyway. I have been encouraging the analytics providers to do a study of the correlation between “going concern” opinion and bankruptcy. How quick and is it getting quicker? Can companies survive it like $LVS seems to have done?

Have to run, but will wrote more later, especially about how this “past results vs projected future” argument to let auditors off the hook ignores SAS 99. And that’s something I think auditors are doing and their clients, the regulators, and the lawyers, so far are allowing it.
Francine

It will be interesting to see what the “independence standards to be promulgated by the SEC” for compensation committee consultants turn out to be. I would hope that we haven’t had the audit firm in a compensation advisory role for a while, given that Regulation S-X 210.2-01(c)(4)(vii)(D) prohibits “acting as a negotiator on the audit client’s behalf, such as determining position, status or title, compensation, fringe benefits, or other conditions of employment.”

With respect to the going concern, with all due respect to your on-going war against the current use of the going concern opinion, in the GM case that opinion functioned as intended. The point of the going concern opinion is that the financial statements of the company are presented on a “going concern” basis rather than a liquidation basis. Somewhat arbitrarily, professional standards state that an explanatory paragraph to that effect is required if the auditor thinks the company may not continue as a going concern for the next 12 months. Subsequent facts therefore demonstrate that in 2007, a going concern opinion was not warranted for GM, because it didn’t cease to be a going concern until the middle of 2009. Whereas for the 2008 audit, a going concern paragraph was appropriately added.

Now, you can certainly argue (and I have) that there would be a benefit to something like an audit that provides a more analytic exploration of the relationship between a company’s past operations and its projected future results of operations. But that is not, and never was, the function of an audit under historical custom or professional standards. That task is frequently performed in financial due diligence. But it would be complex (though not necessarily impossible) to deliver a financial due diligence report, which is quite lengthy and restricted in distribution, to the broad public in the way the auditor’s opinion is delivered. In addition, the scope of additional legal liability for the auditors in that scenario is potentially vast, since they would be speculating on future results (which are inherently uncertain) rather than certifying the accuracy of past statements.

You have generally held auditors and audit committees responsible for companies’ operating failures. I have two thoughts on that.

1) To some extent, auditors may be able to provide more insight than they currently do with respect to a company’s operations, as I discussed in the preceding paragraph. However, as I mentioned and you know, that is not and never has been within the scope of the audit. If you think that should change (and I don’t necessarily disagree) then I am certainly open (as I think are many auditors) to a workable mechanism to change it. But I think it’s unfair to blame the auditors for following a hundred years worth of accumulated practice and standards.

2) To some extent, a company’s failures are never going to be due to matters that are reasonably the subject of financial audit or due diligence. In one of my very first audits (which was a long time ago on a different continent), the company incurred massive cost overruns on a capital project due to faulty engineering assumptions. There was a huge scandal, congressional investigations, and I arrived at the client one morning to discover they had fired the entire engineering department (the degree of cooperation I got from the accounting department increased amazingly after that). But there never was an accounting problem. I doubled the scope of my testing of capitalized costs (which had been quite high from the beginning) but every last capitalized expenditure was legitimate from an accounting perspective. It was just bad surveying and engineering, properly accounted for. (At the time, there was no impairment standard on local GAAP – under current standards, while the expenditures still would have been appropriately capitalized, the overall project almost certainly should have been impaired.) And to some extent, that will always be the case with accounting – it is the language we use to communicate financial results, but good accounting cannot make bad operations into good operations. (For that matter, bad accounting doesn’t necessarily make good operations into bad operations, although that outcome *is* possible.)

Best regards,
AA