• Continuing The Conversation: If Auditors Weren’t There, Why Not?

    By • Dec 14th, 2009 • Category: Latest, Pure Content, The Big 4 And Globalization

    Jim Peterson and I talk often.  It was my lucky day when I found him writing for the International Herald Tribune about auditors and litigation and the future of the profession.  There’s quite an archive there to draw from.  Jim not only has the experience but the chops to write about the subjects that I feel strongly about.  Albeit I’m a little more fun, but…I told a mutual admirer recently not to judge me more beautiful than Jim.  He hasn’t seen Jim in stilettos nor me in a bow tie…

    Jim opened a dialogue with me and the others who write frequently on this topic, like Dennis Howlett and Richard Murphy, via his post today at Re: Balance.  The subject is, “If not, why not…” We’re talking about the auditors’ failure to be a force either before, during, or after the financial crisis.

    “Here – in response to the always tart-tongued Francine — is why the auditors weren’t there:

    The simple if depressing reason is that their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism — having lost any value it may once have had, except for legally-required compliance (here).

    If that single page disappeared from corporate annual reports, no honest user of financial information would admit to missing it. Nor, offered the choice, would any rational CFO pay the fees to obtain it.”

    If no one but me asks, since no one cares, then what are we doing here?  Only legally required compliance keeps us walking like dizzy children through this hall of mirrors, never reaching sunshine.

    “…the fundamental issue of trustworthiness – on which the entire value of the auditors’ franchise perilously rests – is put under scrutiny when they are effectively sidelined for want of influence and capacity to persuade.”

    The Securities Act of 1933, together with the Securities Exchange Act  of 1934, created the government- sponsored franchise and oligopoly which is the public accounting industry in the United States. These laws also, by default, cover all securities listed on US exchanges (SROs), since the SEC “regulates” those, too.

    The goals of the audit requirements in the Securities and Exchange Act of 1934 are pretty straightforward, if you ask me:

    SEC. 10A. AUDIT REQUIREMENTS.

    (a) IN GENERAL.—Each audit required pursuant to this title of the financial statements of an issuer by a registered public accounting firm shall include, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission—

    (1) procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts;

    (2) procedures designed to identify related party transactions that are material to the

    financial statements or otherwise require disclosure therein; and

    (3) an evaluation of whether there is substantial doubt about the ability of the issuer to

    continue as a going concern during the ensuing fiscal year.

    Granted, there are quite a few “deeper meaning” phrases within this short text. Those words have been litigated to death in the ensuing years.  But when you look at the end result – whether the audit opinion in its current form is accomplishing any of these objectives – I think we can say “no” in too many cases.
    Does anyone count on the auditors opinion anymore to do any of the above, enfin?
    I can name several failures of each of those objectives, just in the last year! The failure of the auditors to mitigate, warn, or contribute to the solutions for the subprime “crisis,” a.k.a. the subsequent financial “crisis,” have been described in this blog numerous, numerous, numerous times.
    Let’s look at those examples:
    (1) procedures designed to provide reasonable assurance of detecting illegal acts
    Can you say Madoff,  Satyam?
    (2) procedures designed to identify related party transactions that are material…
    Satyam again and the AIG/Goldman Sachs counterparty asset valuation discrepancy issue. In general, the use of SPEs, VIEs, and the QSPE concepts specified in FAS 140 had been criticized, particularly in light of recent market turmoil tied largely to origination (and related issues involving securitization) of subprime mortgages.
    (3) an evaluation of whether there is substantial doubt about the ability of the issuer to
    continue as a going concern during the ensuing fiscal year.
    How about the utter lack of meaning to the GM going concern opinion when it was finally issued?  And then there’s the fact that none of the financial firms that were bailed out, taken over  or went bankrupt had received going concern opinions from the auditors even though all had annual reports issued less than a year before.
    In general, no one cares about the current auditors’ opinion except when it’s not there. It’s a page in the annual report, a box to check off when doing “due diligence”.  If you need one more good example of the irrelevance of the substance versus the form of an auditor’s report, just look at the recent of Canopy Financial.
    From a report by Monadnock Research:
    “Officers of Canopy allegedly forged audit documents, claiming they had been prepared by KPMG. The complaints also say that doctored bank statements were prepared for Northern Trust Bank account balances. Other significant financial and accounting improprieties were also discovered.

    While KPMG was never appointed as Canopy’s auditor, the firm was hired to provide a SAS 70 (Statement of Auditing Standards No. 70) report. A SAS 70 is intended to provide information about the internal controls in place at an audited company.

    During the process of communicating about engaging KPMG for services, it appears that Blackburn was provided sample documents by a KPMG advisory partner via another Canopy executive. Those documents, allegedly, were later used to prepare the bogus attestation.  According to the SEC complaint, the fraud was uncovered when Canopy’s newly employed general counsel began searching for a new CFO and contacted an acquaintance at KPMG for potential candidates. The lawyer sent what he believed were legitimate KPMG audit reports and financial statements to the acquaintance.

    According to the Blackburn criminal complaint, KPMG said it had never performed an audit of Canopy’s financial statements. Upon discovering the fraud and that someone at Canopy had used KPMG’s name to perpetrate it, the firm sent Canopy a Cease and Desist letter on 3 November for using KPMG’s name without its authorization or consent.”
    Canopy raised $75 million in a private placement offering from Spectrum Equity Investors and others in July and August 2009.  Financial Technology Partners was the investment bank that worked as strategic and financial advisor in the $75 million private placement transaction. Where were the law firms?  Who is on the Canopy Board of Directors/Advisors?  It looks like the General Counsel is new and there was no CFO at the time of the private placement.  So no one, no one who should be doing due diligence, ever spoke to the auditors, ever verified the accuracy or legitimacy of the financial statements, ever spoke to anyone independent of management about the financials?
    In this case, and in so many other I can imagine, the “certified” financial statements and auditors report are pieces of paper put in the file, checked off, all the better because they came from a Big 4 audit firm.  Did KPMG or someone in KPMG, their SAS 70 provider, make this too easy for Canopy’s executives?  Did someone from KPMG pose as more than just providers of the SAS 70 “good housekeeping seal of approval” ?  Was the idea to get the real audit once everything was lined up? We shall see as the investigation and litigation continues.
    The point is no one cared, no one looked any deeper, no one thought it was important enough to meet the auditors, invite them to lunch, kick the tires on the numbers with the “experts.”  Sort of like the feeder funds’ attitudes towards Madoff’s storefront, sham auditor David Friehling.
    Is it any wonder the auditors were not in the room when real valuations and the fates were decided for Lehman, Merrill Lynch, Bear Stearns, Wachovia, Washington Mutual, Fannie Mae and Freddie Mac?

    Inside video from nearly the end of the film, “My Dinner With Andre”. Roger Ebert said it was the only film he knew of with no absolutely clichés.

    Main page photo courtesy of the blog, Cassandra Does Tokyo.

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    44 Responses »

    1. Have you ever started doing something at your job that had a legitimate purpose and filled a well-defined need? You continue to do this thing and it evolves and changes over time until you wake up one day to find out the thing you are doing bears little or no resemblance to the task you originally designed and you can’t quite figure out what the thing DOES do for you?

      It’s like that.

      From 1933 until now, there hasn’t really been a evaluation of the core assumptions around audited financials (IMHO). The requirements have evolved and become more detailed, stringent, as we go through the motions of continually fighting the last war. Add to it the institutionalization of the main players (audit firms, regulators, accounting designation self-regulatory bodies), and it’s easy to see how we’ve lost the plot.

      I’ll draw an analogy to the union movement. Again, a clearly defined need existed and a specific remedy was enabled. But look today, what is the primary focus of a labor union? The continuity of the union.

    2. I am loving this discussion… I struggle all the time with my actual love of numbers (yes, nerd) and playing with accounting information to make it useful and relevant and then all the times the “old guard” says oh, that doesn’t matter. It’s not material. I don’t mean things that are truly not material, I mean things they just don’t want to adjust. I eventually just opened up my own firm, but still the pressure is there. And of course, now I manage external audits and you should not get me started on there. Suffice it to say that we do not need to make a control procedure for payroll when there is no payroll. None. GRR. :)

    3. If auditors and their output are so irrelevant, why is there so much discussion about them?

    4. @3 There really isn’t enough discussion. That’s why I’m here. The auditors are still “there”, sucking up a lot of time and money that could be better spent on more effective assurance.

    5. Could you say an audit is like the purification of drinking water? Nobody would really notice if, as a society, we stopped doing it (as long as the water didn’t stink or taste funny), but long-term the consequences would become obvious. My point is, just because we don’t notice it or pay it much attention doesn’t mean it’s not important.

    6. GREAT READ!!!

    7. I agree this is a great discussion on a very important topic. Ironically, these tales of auditors bending to the desires of their clients doesn’t stop with publicly traded companies, nor does it end with Big 4 or other international firms. Unfortunately, it also happens regularly in the realm of middle market companies being audited by local firms. Even after 12 years in the profession, I’m constantly amazed at how partners (especially in this economy) will allow clients to persuade them to make (what I believe is) a poor decision… then describe it to the more skeptical engagement team as a “business decision”.

      But what’s the point? I’m always interested in this discussion, but what I’m really interested in is a solution. How do we get from where we’re at to where we should be? Anyone?

    8. @MattCPA – what does the more skeptical engagement team members do when they hear that it’s a “business decision”?

    9. I’m with ClownCollege on this one. I have more questions as well. For example: What percentage of audits are deemed unsatisfactory? (unsatisfactory = restatements, frauds, bankruptcies without GC Opinions etc).
      Thanks for the post, but I think we need to push a little more and zoom out a little more from the past year or two and the companies involved in the mess before we write off the whole auditing and attestation system.

    10. BBC – I depends on the circumstances. But is that really the point?

    11. If you do away with the external auditors what do you replace them with? Government regulators like the SEC and the FDIC haven’t proven themselves any more effective at detecting fraud or going concern issues that the audit firms have. The idea has been floated of having each exchange traded company purchase insurance against the financial impact of future restatements or fraud, but for that to work you would merely replace the auditors with the insurance industry, who would need to do their own “audits” before they would agree to underwrite such large risks. What other alternatives exist to having an annual audit?

    12. Having a manager or staff speak up when partners are making unethical decisions is part of any good firm’s internal control and is part of the responsibility and duties of being a CPA. So, yes, it is the point. It seems to me, that any manager or staff that wouldn’t speak up in that type of situation would be making a “business decision” as well.

    13. While I think the system could definitely use some alteration in order to fix some serious flaws in independence issues, I agree with Oseloka Albert Okagbue (what the hell kind of handle is that anyway) in that we need to get some perspective on the situation. We hear about the high profile cases in the media because it is sort of en vogue right now. What you don’t hear about is all the successful audits that are occurring among the remaining thousands and thousands of companies out there. This is nature but indeed frustrating for those within the auditing community as I do believe that most feel their job is important and try to do the right thing on a day-to-day basis. My fear is that the media attention will prompt another knee jerk response to this issue and force the creation of some less-than-optimal oversight or legislative solution.

      Robert
      AccountingNation.com

    14. Not to sound flippant, but an audit firm looking to vindicate itself by pointing to all the audits that didn’t fail is like a surgeon trying to excuse his killing of a patient on the operating table by saying “look at all the patients I didn’t kill”.

    15. BBC – It can’t be that you blame the “failures” of the audit industry on the staff/seniors not standing up to the partners… can it?

    16. @ Philip J. Fry: Few things in this world are built or designed such that ithey work perfectly all the time. Audit opinions say “reasonable assurance” and “material misstatement” for a reason, so yes: We should be asking about how many rotten apples are in the barrel because if we can’t quantify it, there’s no logic supporting the idea that the entire barrel should be discarded. So Mr. Fry, can we “audit” the barrel please?

    17. Most audit failures are a lack of industry knowledge (imo) . . .but there are audit failures that involve an auditor (partner/manager/staff) looking the other way and not performing their duty to the public and the users of the financial statements. . . .and, in your case above, the manager who doesn’t say anything when a partner isn’t performing his duty to the public is just as responsible for the audit failure as the partner

    18. @14…what’s wrong with that? Even good doctors make mistakes….I wouldn’t expect them to hang up their scalpel because they lost 1 person out of thousands that they saved. Maybe I’m out of the norm on this but you have to allow for some variation in life. An audit is supposed to provide reasonable assurance, not absolute. An audit firm has many engagement teams…some good…some bad. The whole system can’t be vilified because of isolated events.

    19. @15

      interesting question

      seniors and managers not challenging such partner decisions is a major problem and is closely linked to the fundamental problem with the auditing profession – performance incentives are too short term and divergent from the public interest.

    20. My original thoughts in detail:
      There has always been a lot of talk on this blog and others about the audit model being outdated or not useful. What percentage of audited financial statements end up in restated, or with “big problems”? I really think we should look at that and state it more explicitly. It doesn’t seem enough that we “can name several failures of each of those objectives, just in the last year!” (as Francine said). There is a lot of risk consideration in auditing, and financial statement readers should know that. Most auditors reading this blog know that their audit methodologies are not designed to provide absolute assurance (usually something like 95%), so there is a statistical chance that something bad is going on which you won’t find. Let’s not cry when that 5% occurs, because that is risk that we deemed acceptable.
      It is a little too convenient for these arguments that we can name bad apples that are BIG companies – but again, what percentage of Audits is that? Is the problem more about audits of enterprises engaged in certain types of activities (e.g. financial instruments)? Is it a problem more about audits of enterprises of a certain size?

      Another thing: We criticize Sarbanes Oxley sometimes, and I have heard even from fellow accountants and auditors that controls mean nothing and don’t prevent anything. However, I recently read an article on CFO.com (Dec 2 – “Does Sarbox reduce restatements”) which stated that for filings between November 2007 and November 2008 “5.1% of companies that both reported effective internal controls and had their auditors attest to those controls later restated their financial results. In contrast, 7.4% of companies that reported effective controls but did not get their auditors’ signoff later had at least one subsequent restatement”. Cost v.s. benefit is still under debate, but there can’t be doubt that “benefit” exists. Speaking of controls, there is this nasty thing called “Management Override” which we still do not have perfect or absolute assurance over – and from reading your blog and other discussions, that seems to be where all the bad stuff happens.

      If one is investing in a company, he/she actually relies most on management, NOT the auditors, because the auditors rely significantly on management representations (whether they like it or not). Auditors audit what is there, not what isn’t. Unrecorded liabilities are a perfect example. When you look at successful investors like Warren Buffett who buy whole companies, you’ll see that they base a fair amount of their decisions on their own instincts and perception about management’s abilities, competencies, and values. These things are nearly impossible for the average stock investor to assess, but ultimately determine how the management behaves. Why is this important? Because of “tone at the top”. (Note that one of Buffett’s preferences when buying a company is that the management remain the same.) I personally think that the biggest benefit of all types of audits is how they can affect the behavior and decisions of reasonable, honest people. Has anyone researched this? Even if accountants are former auditors, they know that auditors themselves will decide the extent of audit tests and that unpredictability is good if it has any influence on the person. Maybe we auditors are not scary enough anymore? Is that the issue? Are there too many former auditors in the financial world who don’t have a healthy “fear” of our ability to “expose” them?

    21. @18 thank you. This website spends an inordinate amount of time vilifying a profession because of a few bad apples. Granted, those bad apples can be pretty toxic, but to say that an audit doesn’t have value misses the whole point. I am a partner in a CPA firm, so everyone knows where I’m coming from, but if you spend any time talking to audit committees and CFOs like I do, I can assure you that quality audits are well thought of. As to this article, any investment firm or company doing due diligence that doesn’t consult with an accountant is an idiot.

    22. @ 18 – Let me clarify the whole medical analogy. Let’s say your surgeon performed heart surgery on you but because he was careless (thinking about the golf tournament he had the next day) he sewed you up with a scalpel or scissors still inside your chest cavity. You drop dead the next day because that scalpel puntured your aorta. Will your family take comfort in the fact that he performed hundreds of other operations without killing his patients? Or will they demand that the surgeon lose his medical license and be disciplined because his carelessness represents a menace to the public?

      Same thing applies to this profession. The whole reason why we have guidance and accounting pronouncements is to provide the framework for our public practice. If an auditor chooses to cut corners or look the other way and that cut corner blows up in his face it’s hard to defend his carelessness by pointing out all the other times something didn’t blow up.

      “Reasonable assurance” means we can’t guarantee that our work is perfect, but it doesn’t give us a get-out-of-jail-free card for sloppy work or carelessness.

    23. @22 – I think @18’s analogy is closer to the surgeon who operated on you and you later died because you did not disclose to her a pre-existing condition – Say you are gettign a heart transplant and swear up and down you are not a smoker because without that new heart you are a dead man, yet of course you are smoking two packs a day up until the operation. Yes, she;s a good surgeon and will search for evidence of potential problems before agreeing to operate, and in many other cases her careful approach has discovered issues that she has raised and she has refused to give people clearance as a result of her efforts. But in this case perhaps you’ve lined up your wife and kids to lie for you, she believes you and them – or maybe she’s just human and makes an honest error – and – she gets blamed and sued out of existence. Many more audit failures seem to me to be this – a bunch of crooks and liars in management, or desperate people who lie to try to save the business and themselves. We can and do catch many, but Francine herself might not catch them all.

    24. @21 and 22 – both positions are right. Most audits do a very useful job that goes beyond what ends up being written in the final audit report. However, audits consist of many judgements and getting them all right is very difficult. In response to Francine’s original question – the auditors were there, and mostly doing a good job, but there were sufficient judgemental failures that the resulting litigation is going to last for a long time.

    25. @ 23 – The medical analogy is a good one. Sometimes patients lie to their physicians (management lies to auditor) and then you can’t blame the physician when a problem goes undiagnosed. However, often times the patient will display visible signs of a serious illness and the physician will fail to ask the relevant questions, run the appropriate tests, or otherwise fall short of his responsibility of due care. When that happens the physician, not the patient, is to blame.

      Same thing applies to auditing. When the auditor fails to give attention to the areas of high risk, looks the other way when he sees something questionable, or otherwise falls short of the necessary due care he can’t just blame the client and wash his hands of it. Nor can he point to all the other clients he served who didn’t blow up looking for vindication.

      How many audit failures are due to dishonest client management versus sloppy audit work? Who knows, I suspect that the biggest audit failures suffered from both problems.

    26. The entire process is flawed starting with recruiting. If you recruit people with sales in mind, salespeople generally don’t have the personallity to be a good auditor. A good salesman understands the customers needs and knows how to get the customer to agree with him. A good auditor doesn’t care if the client agrees with him.

      I would also scrap the management report. I know the auditors like to show that they are actually doing something of value for the client. But the mindset has to be changed so that your only concern are the financial statements, fraud and possible illegal acts. You can’t be trying to make recommendations and impress management with how smart you are. It just puts the auditor in the wrong mindset. You can’t be wearing two hats. You can’t be trying to impress the client or his personnel.

      When Arthur Andersen first started his firm, he reportedly built it by establishing standards for his reports that were not followed by other auditors. That’s what is needed today. Each firm has to compete with each other to establish higher standards for their audits. And, I think the SEC needs to give the auditors the flexibility to do this. If a firm wants to state in its report that it is making all efforts possible to look for collusion and fraud and are not misleading, then let them do this. Let’s try to have the cream of the crop rise!

    27. I think one thing that worth mentioning again is that the pressure that arises from the fact that the auditors are getting paid by the clients that they’re providing assurance for. The practice office that I was in was decimated by the recent economy and we lost a bunch of public clients and staff. There was a large public company that was still our client and the partner really needed them to stay with us so I was hearing from the staff that they’re bending over backwards to the client’s requests and deadlines. You have staff working late hours and frustrated, just wanting to get the job done. At 12 at night at the client when you see an issue that could go either way and option A is investigate and give yourself hours more work and potentially tick off the client by going over budget or B pass over it and chalk it up to your own “inexperience” and try to justify it. Which way do you think people may go? This is a very human problem that arises from the very structure of the audit and the profession.

      To continue the medical analogy, if you indulge me, what if the doctor was supposed see if his patient had swine flu and would need to be quarantined for a month for the public safety (hypothetically) and he has this really wealthy client that accounts for 40% of his business (along with his wealthy botox friends). The doctor sees symptoms indicative of swine flu, but the patient fibs about his history and where he’s been. He basically tells the doctor that he can’t be quarantined and he will leave the doctor and will tell all his friends to leave if he writes him down for swine flu. What does the doctor do? Be conservative and write him down and lose his business or justify in his head why it maybe symptoms of something else and take his chances giving him a pass? In either case the doctor is not some evil person, just someone dealing with real ethical decisions.

      This is the reality of the profession and if auditors continue to take a pass on liability for any company failures (granted they’re not responsible for all of them) and just say we’re only giving “reasonable assurance” it’s only a matter of time before people ask the same questions Francine is asking, “what good are you then?”

    28. Meh,

      This is the reason i quit doing audits. It’s a commodity that the accounting firms offer to clients, especially when you start talking about the big firms and public clients. The firms don’t really provide any service other than providing an opinion. The clients often don’t care what you have to say unless what you are saying impacts fees, or whether they get an unqualified opinion. With smaller non-public clients, I think the firms can offer value, however that’s a tiny piece of the over pie that exists. I do believe most CFO’s would pay double the fees for an unqualified opinion and no audit procedures than half the fee and full audit procedures. Audits are disruptive and unnecessary WHEN management is competent and honest. Unfortunately that isn’t always the case.

      I think going away from the current model to government regulations, or less procedures wouldn’t fix anything and would make it easier for fraud. The other good thing about our system is that the audit firms are on the hook for that opinion and they can be sued, which at least gives more assurance that they are in there doing their jobs an at least trying to make sure things are right. The big failures this year were in another country, which I can’t speak to, and a tiny one-man firm that was auditing a business he never should have been (Madoff). If you lessened the hurdles for audit opinions, then the wolves would come out of the woodwork to steal money through fraud.

      Also, there probably is little value on an audit opinion when you start talking about public investors. Public investors are the dumbest money that exists. Once a company is listed, they could probably technically do without the audit without it hurting their stock price. The problem is in going public or pre-public, those investors (or underwriters) are going to make absolutely sure the numbers they are paying for are legitimate, which is where audits would probably come in. I think gauging the entire system on the dumbest investors that exist is probably not the right answer.

    29. David @ 26 —

      I think you have it backwards. The firms recruit good accountants/auditors, and then hold them accountable for being good sales people. Then when that doesn’t work, they hire sales people to held the accountants/auditors sell work.

      But I do agree with your thesis that the first firm to focus on quality, and to deploy and consistently follow standards that enforce quality regardless of other factors and metrics, will rise above the others. Or so I would like to think. But the sad fact is right now that the clients don’t perceive any differences between the firms, and it would take a significant difference to catch the clients’ attention.

      What would be interesting (to me) is if the firms ignored management and went directly to the large institutional investors, and treated those big dogs as if they were the real clients (which in a sense they are). Make the sales pitches to them, not to management. If you could convince, say, CALPERS that your firm provided better quality audits and therefore more assurance that things were on the up-and-up, then they might put pressure on management to hire you, even at higher rates.

      Just dreaming, I guess…

      — Tenacious T.

    30. Certainly, there were audit failures both before and after the crash. However, I think it is unreasonable to expect that an audit would have caught the bulk of the issues and prevented or foretold the crash. There were three specific problems which were (1) assets recorded at bubble prices, (2) unforeseen bankruptcies, and (3) overly optimistic asset pricing models and Value at Risk assumptions. I’ll address each separately and explain why I don’t think an audit could have addressed the problem.

      Assets recorded at bubble prices
      Imagine a company that has $100 billion face value of US Treasury securities as its asset with lives ranging from 3 to 30 years bearing interest at 2.25% to 3.5%. Otherwise the company is very large but unremarkable. It’s historically profitable, sufficiently capitalized and has $150 billion in revenue. A Big 4 audits the company today and has no adjustments at all. The company is rock sold, safe and has exceptional controls and financial reporting.

      Assume that 9 months later the most cataclysmic predictions of the right wing have come to pass. The national debt is up to $20 trillion, the deficit is 16% of GDP, and US inflation exceeds 10%. China floods the market for US Treasuries trying to unload $1.5 trillion worth at as little as $.28 cents on the dollar. The bid ask spread on US treasuries is over 10 cents on the dollar. There are simply no buyers.

      The company, meanwhile, is hemoraghing cash, it can’t borrow, existing debt is being called by the lenders who face their own liquidity crisis and because the US Treasuries that collateralize the debt can’t be liquidated the lenders want cash today, preferably Euros. What was the safest investment on earth less than a year ago is illiquid and nearly worthless. The company is forced into bankruptcy.

      Did the audit fail? Of course not. Auditors value assets based on current market conditions and the current fair value of the assets is the basis for the audit. The market and not the auditor prices the asset.

      In the example I gave I used US treasuries, but that exact scenario is what happened. The only difference is that instead of US Treasuries the investments involved were also considered highly safe and liquid such as auction rate securities, GSE debt, mortgage backed securities secured by peoples homes plus Fannie Mae insurance, plus credit insurance, plus an investment grade credit rating. An auditor can’t and doesn’t audit the market price; he accepts it.

      Unforeseen Bankruptcies
      Lehman and Bear Stearns folded because they leveraged their capital 30 to 1 with short-term debt and invested in long-term assets. Obviously there is risk in this strategy but short-term debt is cheaper than long-term debt and Wall Street firms had done this for years. When the scenario described above hit, lenders refused to continue to extend credit and the companies suffocated from a lack fo life giving capital.

      Is that an audit failure? Assume that it is and the auditors should have issued Lehman and Bear a going concern opinion because the duration of their borrowings was much shorter than the period in which their investments would generate cash flow. Lehman and Bear can’t have a going concern opinion so they change their financial strategy. They now borrow long-term and invest long-term. Profits were generated by the spread between short-term and long-term rates. There is no spread between long-term rates and long-term rates so under the new business model required by the auditors, it is impossible for the companies to make money. The bubble never bursts but they go out of business anyway because the auditor driven business model doesn’t work. Investors aren’t concerned. As soon as the auditors forced the companies to stop taking any risk they pulled their money out of the risk free companies and invested in riskier companies because they offered a better return. The price paid for returns is risk. No risk, no returns.

      If you expect auditors to start treating companies this way, don’t invest in JP MorganChase or Goldman Sachs. Both still employ this strategy. The bets Lehman and Bear made had two sides and they were a zero sum game. JPM and GS won what Lehman and Bear lost. The winners think it was because they were smarter. Maybe the game had to have a winner and a loser and maybe the winners were just lucky. When the music stops next time don’t be surprised if JPM and GS are unable to find a chair.

      Overly optimistic asset pricing models and Value at Risk assumptions
      Wall Street hired MBAs. The MBAs invented 2 new financial instruments. The assets are so new there is not a market for them. So PhDs are hired. The PhDs determine that there is no market but the value of new instrument number 1 is highly correlated to US Stocks. The value of financial instrument number 2 is highly correlated to the value US Treasuries. Values of each instrument can be derived from the market price of the assets to which they are highly correlated.

      This is huge. If fair value can be determined, the assets can be sold for more than fair value by the Wall Street firms who will make money creating and selling the assets. Plus it is low risk. Sure there is risk in instrument 1 and there is risk and instrument 2. But stocks and treasuries are inversely correlated. That means if instrument 1 goes up in value, instrument 2 will go down in value and vice versa. The net value at risk is tiny. Floor it guys. Create and sell as many of both instruments as you can. Each one produces a fee plus a gain since it is sold for more than fair value determined by our model and as long as the total risk of each offsets the other we can afford to carry the risk of trillions of securities with virtually no risk and no capital.

      Auditors audited the fair values and the VAR and based on every possible scenario seen in historical data, the information appears correct.

      This was true until August 2007 when doubt spilled into the market for mortgage securities. Investors in mortgage securities had leveraged their equity to generate higher returns. When the panic hit margin calls went out. Investors assumed the decline in mortgage securities was an aberration so they wouldn’t sell their mortgage securities at such firesale prices. Instead they sold other investments to make the margin calls. Stocks plummeted. bonds plummeted. real estate plummeted. gold plummeted. commodities plummeted. Correlations that had always existed vanished. Everything was correlated and everything was going down. More margin calls hit and everything went down more.

      But that first squall passed quickly and within two weeks everything was back were it started. People who responded to the panic lost money. People who were on vacation during the panic lost nothing. But though the panic in August 2007 caused little real pain in the short term, the long-term impact was substantial. The pricing models were wrong and the VAR models were wrong and now everyone knew it. The correlations that made it possible to carry so much risk comfortably were an illusion. Those investments had to be liquidated or they could kill the investor that held them. Everyone was looking for an opportunity to sell. No one wanted risk and no one wanted leverage.

      What do these three situations have in common? All are completely impossible based on historical data. The US government has never defaulted. Investment banks have always been able to borrow short-term and invest long-term. US Mortgage backed securities have always been a safe investment that generated a generous but reliable return.

      An auditor can’t ignore facts. We don’t set the market price, we take it because the market is the best indicator of the value of an asset. Unfortunately, though the market is always right it is also always wrong. It gives you the best indication of value when I type this “x” but by the time I type this “x” it has reconsidered and given you another price. Usually the change in x is a fraction of a percentage point. Sometimes it’s 50%, 100% or 1000% or more. Anyyone can spot what they think is a bubble but only the market can actually identify a true bubble and once the market shows its hand on a real bubble its too late. Auditors can’t change that.

    31. 1. You are supposed to consider the risks of a certain industry and know the happenings of the economy since it will effect assurance/risk based testing, etc. Lehman was overexposed to MBS, something auditors should have caught on to. The big 4 like to through around the term “best practices,” much of which they accumulate from their work on a variety of clients in the same industry group(s). It is common sense that proper portfolio allocation is of utmost importance. Through best practices and training, the big 4 should be aware and should have seen the risk in a large amount of highly leveraged investments into one type of security, MBSs. Was it ever noted as a risk in documentation, during the SAS 99, etc. If not looked into at all, big 4 should take part in blame.

      2. the big 4 claim to be “knowledge leaders” – are they clueless with all their research

      3. Auditors do not set market prices, however they do test for impairment.

    32. Professional huh?

      On your first point: Assume that Lehman wasn’t sufficiently diversified. What should the audit firm have done? Financial statements with an undiversified portfolio recorded at market value comply with GAAP. Portfolio risk management is business strategy and execution at an investment bank. Are you saying that auditors are now responsible for the development and execution of a company’s strategy? What’s next? Will the auditors tell the auto manufacturers how to design, build and market cars? Will the auditors tell Microsoft how to write software? The point though is that the portfolio was sufficiently diversified. Sure they had lots of MBS. They also had CDS to cover the risk + plus the MBS were collateralized with real esate + American’s actually pay their mortgages + the securities had investment grade ratings.

      On your second point – Assume the audit firm research showed without a doubt that in 18 months US treasuries will be trading at a discount of 70% and assume they are correct. What can they do with that information? Require the audit firm to write down securities trading for $1000 to $300? Investments are recorded at fair value; not some number the audit firm is responsible for making up based on research.

      On your third point, auditors do test for impairment and an impaired asset is written down to fair value which is the market price in most situations. If an investment trades at $100, is recorded by the client at $100 and the auditor thinks only a moron would buy that investment, the auditor can’t write the asset down to an amount less than market value.

      You seem to think that auditors are supposed to be fortune tellers. It’s not sufficient to record the assets at fair value? Auditors have to foresee asset pricing bubbles when Wall Street, the Fed, and Warren Buffett can’t. I’ll assume that is their role for the sake of discussion. Now tell me this. Once auditors master the art of identifying asset pricing bubbles and determining what date they will burst, what exactly are they supposed to do with that information? I know. They could tag this paragraph onto the end of the opinion.

      The Company recorded investments in bonds and notes issued by the United States Treasury at fair value in accordance with accounting principles generally accepted in the United States of America. Profligate government spending coupled with the fact that government securities are trading at a premium to face and a negative yield is a clear indication of an impending freefall in the value of the investments. The astrophysicists lured away from NASA and employed by the company as traders, can’t shake their insane attachment with the fantasy prices on their Bloomberg terminals and FAS 115 to accept reality and write the assets down to one-fifth of the current market price. Accordingly, we disclaim an opinion because the financial statements are presented in accordance with accounting principles generally accepted in the United States.

      Furthermore, the Company’s highly speculative investments in AAA-rated, US government securities of varying maturities raise substantial doubts about the entity’s ability to continue as a going concern.

      that the assets trading in highly liquid markets at prices in excess of face value at the company are myopically and and . ling to purchase them at prices so high that the yields clearly indicates that there is a accept negative yields are so enamored with short-term treasuries they are eager to purchase them at prices so high they with a negative yield ur research indicates that an asset pricing bubble exists in US Treasury securities and though everyone on earth regards them as safest harbor in a storm, we respectfully disagree and suggest that the securities be recorded at no more than twenty percent of their current market value in

    33. TT: Spot on with this quote: “The firms recruit good accountants/auditors, and then hold them accountable for being good sales people.”

      That is my issue with the big 4. I’d argue that you could be a mediocre / poor auditor who is great at sales and make it to partner far easier than a great auditor who is not a sales machine. How do you think that helps the quality of audits? While I understand the realities of having to sell work and grow, it’s not why I joined the big 4 and it’s a reason that I’m glad not to be there any more.

    34. @esa.

      your arguments showwhy the big 4 will have many robust arguments to defend themselves against all the litigation. however, it won’t stop the litigation…

      but if audit opinions were written like you suggest then more people might read them!

    35. @ esa.

      I think we can presume from the failure of the ‘auditor bashers’ to respond to your posts that they are unable to counter your arguments.

      Well done.

    36. @35 – yeah, maybe, or we’re all tired and on a working holiday. I’m too sleepy to read the comments, but maybe I’ll give them a read later because there have been some very thoughtful discussions around here lately. Happy Holidays, everyone.

    37. @esa,

      You make good points. They absolve the auditors, but they still don’t justify why the model is still relevant.

    38. #37 — If you know of a better model that allows us to hold someone responsible for unforeseen future events, I’m all ears but that’s not a job I want.

      A lot of people think the model is relevant though it certainly has flaws. The SEC, institutional investors, financial analysts, etc. all think the model requires tweaking but none suggest wholesale changes.

      If fact, I haven’t heard anyone propose something that even comes close to a reasonable alternative that is actually feasible. If you have ideas on that front, please share them.

    39. Financial professionals believe that our model needs more than a bit of tweaking. I will get back to this after xmas weekend.

    40. My biggest concern is that it wasn’t any secret that the investment banks were in a lot of trouble in 2007. If I remember correctly, in the third quarter of 2007, Merrill Lynch reported huge losses on its CDOs. A hedge fund run by Bear Stearns collapsed in the second quarter.

      Yet, the Lehman and Bear Stearns 2007 financials didn’t reflect the spectacular losses on CDOs. Why? You didn’t even have to do an audit to know that these companies had big problems. You could look at their balance sheet and see that they had billions invested in the CDOs and had leveraged themselves to do so. Maybe an hour of analysis would have given you the answer that these companeis were going down. It was obvious. A company leverages itself to invest in something that collapses is in a great deal of trouble.

      That’s a major problem for me. An audit not detecting a problem that could have been detected by relatively simple financial analysis. I don’t know. If the auditors followed GAAS and didn’t detect the problems, then GAAS needs to be scrapped. GAAS either works or it doesn’t work.

    41. @ David.

      GAAS works fine. If we accept your analysis (that Lehman and Bear Stearns were clearly going to fail based on their 2007 financial statements), which I understand many people argue, then the case against the auditors becomes simply that they simply got their judgements around the going concern assessment wrong. Those judgements are or will be subject of some very long lasting litigation. If it weren’t possible to sue the auditors for enormous multiples of their fees then the debate around this would be over much more quickly.

    42. David:

      You are certainly correct on that point. ML had huge write-offs and Lehman did not. I still believe that the assets were recorded at fair value in both cases but somebodies fair value seemed a little more fair to management than the investors. The mystery is how one investor determined it had enormous losses while another didn’t in the same market. I guess time will answer that question.

    43. @ esa. There is no mystery. It’s called accounting arbitrage. Traders make good money on it.

    44. […] Jim Peterson compiled the top responses to our posts about the future of the audit firms, given their minimal role in preventing, warning, mitigating, or supporting the development of solutions to the financial crisis. To greet the new year, instead of a backwards look at a dreary 2009, this will revisit last month’s lively exchange, initiated by Francine McKenna’s provocative post of December 7, “They Weren’t There: Auditors and the Financial Crisis.” My response of December 13 is here, and hers of the 14th is here. […]

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