Going Concern Audit Opinions: Why So Few Warning Flares?By Francine • Sep 18th, 2009 • Category: Latest, Pure Content, Regulators, Laws, Standards, Regulations, The Big 4 And Globalization
Photo From the Eyes Wide Open Exhibit, Chicago, November 2006.
Lehman Brothers. Bear Stearns. Washington Mutual. AIG. Countrywide. New Century. American Home Mortgage. Citigroup. Merrill Lynch. GE Capital. Fannie Mae. Freddie Mac. Fortis. Royal Bank of Scotland. Lloyds TSB. HBOS. Northern Rock.
When each of the notorious “financial crisis” institutions collapsed, were bailed out/nationalized by their governments or were acquired/rescued by “healthier” institutions, they were all carrying in their wallets non-qualified, clean opinions on their financial statements from their auditors. In none of the cases had the auditors warned shareholders and the markets that there was “ a substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited.”
“…The auditor’s evaluation (under AU 341) is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report. Conditions or events that may indicate there is substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time include, for example –
Negative trends – for example, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, and adverse key financial ratios
Other indications of possible financial difficulties – for example, default on loan or similar agreements, denial of usual trade credit from suppliers, noncompliance with statutory capital requirements, and the need to seek new sources or methods of financing or to dispose of substantial assets
Internal matters – for example, work stoppages or other labor difficulties, uneconomic long-term commitments, and the need to significantly revise operations
If you have been reading the financial press over the past several months, I imagine these types of things sound familiar to you. I think it is reasonable to assume that more companies than in the past will exhibit one or more indicators of substantial doubt. If such indicators are present, I encourage you to engage in a dialog with your client’s management and audit committee about these matters as soon as possible.”
So I asked Don Whalen, Director of Research at Audit Analytics, to update their March of 2009 study that looked at trends in “going concern” opinions issued by auditors. In April 2009 Compliance Week quoted Mr. Whalen as saying that:
“If filing patterns for 2008 year-end financial statements hold steady, an increasing number of accelerated filers listed on major stock exchanges will get audit opinions expressing doubts about their ability to continue as going concerns.
According to analysis of going concern opinions filed by auditors for previous years and for early 2008 results, Audit Analytics says 23 percent of all 2008 audit opinions for publicly listed entities will say there’s a question about whether the entity will still be in business a year later. To boot, a larger-than-usual number of those audit opinions will be handed out to major entities listed on major exchanges.”
Well, Mr. Whalen made a pretty damn good prediction. According to updated figures, obtained exclusively this week by re: The Auditors, the percentage of audit opinions with “going concern” opinions went up to 21.4% in 2008 versus 20.88 % in 2007 and less than 20% in all prior years going back to 2000.
Because the total number of Audit Opinions dropped by 7.2% in 2008 (15773 opinions in 2007 compared to 14641 in 2008), the absolute total number of going concerns went down in 2008 even though the percentage went up. There is also a noticeable spike in the number of “going concern” opinions for large accelerated filers.
Another interesting comment Mr. Whalen made to me explained what happened to those 2007 “going concern” opinion companies.
“I was a little surprised that only 14,161 auditor opinions were filed with the SEC in 2008. This number is much lower than the prior year’s amount of 15773. Of the 3293 Going Concerns in 2007, here’s the overview of the status of some of those companies today:
· 826 are now a Shell, Blank Check, or Non-Operational Establishment;
· In addition, 184 different companies filed a termination with the SEC;
· An additional 13 uncounted companies filed a notice with the SEC of a Chapter 7 bankruptcy; and
· This does not include an addition 49 companies that went dark (have not filed with the SEC in 18 months).
The total of the categories above equals 1072 companies. Therefore, over 1000 companies that had a “going concern” opinion in 2007 seemed to have stopped operating as a substantial entity. (Note from fm: I would say that was a pretty good early warning system! )
I also noticed that outside the group of companies listed above, an additional 64 would be characterized as emerging companies (companies that filed an S-1 or equivalent but has yet to file a periodic report such as a 10-KSB).”
So what does this tell us about the value of the “going concern” opinion to warn shareholders and the markets of companies that are fragile, in a precarious state, engaging in risky business or trying to operate with an inadequate business model in risky markets? Tells me it’s pretty damn valuable and should be encouraged even more. And when it’s not provided and should have been, the auditors should be held responsible.
And to do that, someone like Judge Jed Rakoff needs to go “all activist on their auditor tails” versus being “pragmatic” like Judge Richard Posner.
Attitudes such as those previously expressed by Judge Posner regarding the auditors’ role in the capital markets system serve us as poorly as those of the judges who used to sign off on SEC settlement with no questions before Judge Rakoff came along. Judges like Posner are letting the watchdogs for the capitalist system and the shareholders – regulators and auditors – off the hook.
“Posner: 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….
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!…Your trends? That’s what the company knows. [Plantiff’s Attorney: You’re right. Here’s what the auditor’s responsibility under SAS 59...]
Posner: That is too vague for me…”
In describing the essence of the case, Judge Posner states:
“The argument has to be that had Ernst & Young included the going-concern qualification in its audit report of October 1995, Bank One would have acted sooner, precipitating an earlier liquidation.”
Unfortunately, in this case, the plaintiff’s attorney failed to convincingly explain the function of an audit report and the proper audience for it, in particular for a small private company heavily dependent on a bank credit line. This was unfortunately necessary for Judge Posner.
At the same time, Judge Posner’s renowned “pragmatism” gave him cover for his supercilious expressions of frustration and boredom with the exposition of the actual standards by which he should be judging the auditor’s performance of their duties.
Judge Posner found no connection between the auditor’s lack of performance of a proper SAS 59 analysis, which would have likely resulted in a going concern opinion, and the delay in an inevitable involuntary bankruptcy. A “going concern” opinion would have triggered a breach of loan covenants immediately, given that the company had a contractual obligation to provide the bank an audit report with an unqualified audit opinion to maintain their line of credit.
(I am assuming the minimally profitable small family owned company that was the subject of this suit would have no other reason to pay big bucks to have an audit by EY nor to delay submission of it to their bank than because a clean audit was required to maintain their bank line of credit.)
What Judge Posner found “too vague” was the description of the auditor’s responsibilities under SAS 59:
“…The auditor’s evaluation includes considering whether the results obtained in planning, performing, and completing the audit identify conditions and events that, when considered in the aggregate, indicate there could be a substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time. It may be necessary to obtain additional information about such conditions and events, as well as the appropriate evidential matter to support information that mitigates the auditor’s doubt.”
Even though the standard details the kinds of internal and external factors that the auditor must consider, Judge Posner writes in his opinion:
“Elsewhere the standards emphasize that the auditor must have ‘an appropriate understanding of the entity and its environment.’ Yet nowhere is the auditor required to investigate external matters, as distinct from “discovering them during the engagement.” An accounting firm that conducts an annual audit of a multitude of unrelated firms in a multitude of different industries cannot be expected to be expert in the firms’ business environments…”
Why am I revisiting a decision from July of 2007 that the auditor won?
Well, this case was about more than just a discussion of a “going concern” opinion or the lack thereof. It is also a case where Judge Posner’s pragmatism and wish to be pithy and memorable gives us additional case law on the controversial theory of liability called “deepening insolvency.” The opinion provides a short discourse on the theory, in particular for assessing damages when an auditor fails to stop the clock with a “going concern” opinion and opens themselves up to claims of damages for “deepening insolvency.
In another more recent case that skirted around the “deepening insolvency” theory, the auditors, PricewaterhouseCoopers, lost big.
“On September 9, 2008, the United States Court of Appeals for the Third Circuit in Philadelphia affirmed a $119.9 million jury verdict and $182.9 million judgment entered in 2005 by a New Jersey federal trial court against the accounting firm PricewaterhouseCoopers, LLP (“PwC”) on behalf of Jones Day client Vermont Insurance Commissioner.
That verdict, characterized at the time by The Wall Street Journal as one of the largest ever handed down against one of the “Big Eight” accounting firms for audit failure, was in favor of the Vermont Insurance Commissioner as receiver for the insolvent Ambassador Insurance Company…PwC, was found negligent for failing to properly audit the company’s financial statements, and particularly its loss reserves, which negligence allowed the company to remain in business beyond the point of solvency…The judgment against PwC came after a nine week jury trial. The appeal raised, among others, issues concerning the scope of an auditor’s liability when there are allegations of management misconduct, as well as questions concerning the availability and appropriate measure of damages available in auditing malpractice suits brought by insolvent corporations or their receivers.
In one of the most important and extensive discussions of auditor liability by a federal appellate court in years, the Third Circuit sided with the receiver of Ambassador on both issues. The Court held that, under New Jersey law, misconduct of management cannot be asserted as a defense against the company by an auditor who participated in the misconduct. In addition, the Court clarified recent decisions concerning “deepening insolvency” damages by holding that an increase in the liabilities of a company, even if insolvent, is damage to the company and may be recovered from wrongdoers if negligence is proven.”
I’m not sure if Steven Thomas, the attorney representing the New Century Trustee intends to explore this issue when arguing their suit against KPMG US and KPMG International. I can’t think of a better case, though, to give it a shot. There’s smoking gun evidence against KPMG of potential malpractice and complicity in the fraud for the sake of their fees, which prevented them from issuing a “going concern” opinion or otherwise warning shareholders, regulators and the markets that something really, really bad was going to happen.
“To account for the risks it was taking, and to provide comfort to creditors and investors to whom it disclosed these risks, New Century hired a professional, independent well-known certified public accounting firm to audit its financial statements. The auditor was KPMG LLP. KPMG LLP was retained when the company was formed in 1995, and served as New Century’s outside auditor until April 27, 2007, when it resigned, having issued twelve unqualified audit opinions on New Century’s financial statements. These opinions certified each of New Century’s consolidated balance sheets and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity and cash flows.
…Beginning in at least 2005, these loan repurchase provisions began to have an increasingly material, and ultimately overwhelming negative impact on New Century’s financial statements… the trend of increasing repurchases indicated that the most significant piece of New Century’s business – its loan portfolio – was severely weakened.
KPMG LLP was fully aware of this trend. Its own workpapers note that the repurchases had more than doubled from 2004 to 2005, going from $135.4 million to $332.1 million. Even with this increase in the rate of repurchases — a clear indicator of weakness in the loan portfolio — KPMG LLP failed to expand its procedures or testing of New Century’s reserves. Indeed, although KPMG LLP expressly acknowledged in its workpapers that the risk associated with the portfolio had gone from low to high, KPMG LLP did not expand its audit work in response to this increased risk.”
The question for all of those who can advocate on behalf of shareholders – regulators, Attorneys General, and the plaintiff’s bar – is:
Why aren’t there more “going concern opinions” issued earlier and more emphatically, and why weren’t there any for the most notorious of the “financial crisis” firms?