Top Ten Things Lawyers Should Know About AuditorsBy Francine • Sep 15th, 2010 • Category: Latest, Pure Content, The Case Against The Auditors
In preparation for my appearance tonight at the New York County Lawyers Association program, A Crisis of Our Own Design, I’ve put together some information about the accounting industry for lawyers.
Lawyers and auditors often work hand in hand. The modern corporation can’t live with them but they, nevertheless, can’t live without them. Executive compensation, mergers and acquisitions, taxes, financial disclosure… Accounting and the legal professionals weigh in, often together, sometimes in opposition, on decisions that affect all of us as investors, employees, vendors and customers.
Even though the largest global accounting firms are organized as partnerships – just like law firms – the similarities pretty much end there. Professional services is a unique industry – law, accounting, consulting, technology, executive search, even advertising have many common methods and madnesses. One of the primary differences between law and audit, the specialized service provided by accounting firms to a captive audience, is the client perspective.
In the Matter of: CHARLES E. FALK, CPA…The Commission’s Codification of Financial Reporting Policies, which interprets Regulation S-X, prohibits members of accounting firms from acting as counsel to the firm’s audit clients. Specifically, Section 602.02.e.i. of the Codification of Financial Reporting Policies states that “[c]ertain concurrent occupations of accountants engaged in the practice of public accounting involve relationships with clients which may jeopardize the accountant’s objectivity and, therefore, his independence . . . . Acting as counsel [is one of the] occupations so classified.” Section 602.02.e.ii. of the Codification of Financial Reporting Policies explains that a “legal counsel enters into a personal relationship with a client and is primarily concerned with the personal rights and interests of such client. An independent accountant is precluded from such a relationship . . . because the role is inconsistent with the appearance of independence required of accountants in reporting to public investors.”
That prohibition is grounded in the fundamental conflict that exists between the roles of independent auditor and attorney. Auditors have an obligation to the investing public to be skeptical about the information reported to them by their clients, which demands total independence from the client at all times. Attorneys, on the other hand, have a duty to serve as the client’s confidential advisor and loyal advocate.
The auditor’s role is to be a gatekeeper. A watchdog. An advocate for the shareholders. Their true client is not the executive who contracts with them and pays the bill.
This is their public duty.
…By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times, and requires complete fidelity to the public trust. To insulate from disclosure a certified public accountant’s interpretations of the client’s financial statements would be to ignore the significance of the accountant’s role as a disinterested analyst charged with public obligations.
This public obligation is mandated and subsidized by a government-sponsored franchise. All companies listed on major stock exchanges must have an audit opinion. Audit firms are meant to be shareholders’ first line of defense, and they are hired by and report to the independent Audit Committee of the Board of Directors not the company’s executives.
Today is the second anniversary of the Lehman Brothers bankruptcy. As such it is an honor to be on a panel tonight with Anton Valukas, the Lehman Bankruptcy Examiner. It was his report that brought auditors, finally, into the discussion of the causes of the financal crisis. It was Valukas’ report that introduced “fraud” into the dissection of the financial crisis. My remarks tonight will touch on the now tenuous relationship between auditors/audits and identifying, mitigating, and preventing fraud.
Mr. Valukas highlighted several issues – colorable claims – where Lehman shareholders and society as a whole should hold Ernst & Young, Lehman’s auditors, liable.
There are two specific issues I’d like to highlight now, in preparation for our discussion tonight. I think they deserve more scrutiny and, potentially, the bright light of a trial.
First, there was an ongoing contradiction between the accounting treatment ( a sale transaction) and the disclosure (a financing transaction) of Repo 105 transactions by Lehman. Ernst & Young, Lehman’s long time auditors and designers of the Repo 105 strategy, knew the accounting treatment used was an aggressive interpretation of the accounting standards. The treatment was blessed by a UK law firm. However, financial statement disclosure by Lehman always characterized repurchase transactions as financing arrangements.
Auditors are responsible for reviewing the interim financial statements, including the footnote disclosures every quarter end. Their job is to make sure, amongst other things, that disclosures match the accounting and are sufficient to support the public investors’ right to transparency of financial information. The existence of a contradiction between Lehman’s accounting treatment of Repo 105 transactions and a lack of matching disclosure of this treatment is supported by the examiner’s report.
Lehman Bankruptcy Examiner’s Report, Volume 3, pages 1037-1038
Moreover, in addition to its duty to report a determination that there is evidence that fraud “may” have occurred, Ernst & Young was required to discuss with the Audit Committee the quality of Lehman’s accounting principles as applied to financial reporting, see AU § 380.11, which would include moving $30‐$50 billion temporarily off the balance sheet at quarter‐end through overseas “true sale” legal opinions that could not be obtained in the United States. Indeed, AU Section 380.11 states that auditors should discuss accounting policies, unusual transactions, the clarity and completeness of the financial statements, and unusual transactions with the audit committee.
Specifically, that standard states that an auditor:
should discuss with the audit committee the auditorʹs judgments about the quality, not just the acceptability, of the entityʹs accounting principles as applied in its financial reporting. . . The discussion . . . should include such matters as the consistency of the entityʹs accounting policies and their application, and the clarity and completeness of the entityʹs financial statements, which include related disclosures. The discussion should also include items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements.
Secondly, another compelling negative for EY, in my opinion, is EY’s claim in later public statements in response to the Lehman Bankruptcy Examiner’s report of an arbitrary cutoff for responsibility for the audit after the 2007 10K. Lehman remained an EY client, up to the bankruptcy in September 2008. This period included two more 10Qs.
Although the Lattanzio decision typically limits responsibility for auditor’s opinions to only the annual report, this is because typically the quarterly reviews are done off line, with no written report or opinion included in 10Qs. (The Second Circuit reaffirmed in Lattanzio v. Deloitte & Touche LLP (Warnaco Sec. Litig.), 476 F.3d 147, 154-156 (2d Cir. 2007) that there’s no auditor liability for alleged misstatements in unaudited quarterly financial statements.) However, in the Lehman case, and for many other financial firms, EY and the other large audit firms consented to inclusion of signed reports of their quarterly reviews (as opposed to an opinion which has a very strict definition in the standards and the law) in the two 10Qs for 2008.
I think EY is vulnerable on this point.
So, without further ado…
“The Top Ten Facts Lawyers Should Know About Auditors”
A list à la David Letterman: the Top Ten facts that attorneys – regulators, legislators, judges, defense and plaintiffs’ bar – should know about the Big 4 global audit firms:
10. The Big 4 audit firms don’t bother looking for fraud. Why? First, it takes time and money to perform a detailed fraud risk analysis (SAS 99). But instead of supporting fraud risk analyses, in the post-SOX 404 environment, CFOs are back to pressuring auditors to reduce their fees and to do more for less—instead of more for more. Second, senior management is almost always the source of fraud risk—but that’s who audit firms see as their client because that’s who pays the bill. Who loses? Investors and the capitalist system. How else to explain Big 4 audit firms as auditors of all the major feeder hedge funds that poured billions into Madoff’s fund and yet none of them saw anything, heard anything or said anything about the numerous fraud red flags so obvious to anyone like Markopolous that looked?
9. The Big 4 firms aren’t comfortable being watchdogs. They don’t even like being CALLED watchdogs, in spite of a 1984 Supreme Court decision that reiterated their public duty. When an audit misses the really big frauds, the whoppers, their first move is to evade responsibility. The Big 4 don’t even like being called AUDITORS. Rather they provide “ASSURANCE Services, ” and act as “TRUSTED ADVISORS”. This isn’t just rhetorical. It’s a cynical PR move and an effort to limit their liability.
8. Big 4 firms should NEVER be asked to conduct internal investigations into alleged illegal activities for their audit clients. But companies continue to pull them into messy situations. A whistle-blower, allegations of illegalities or improprieties, concern about corruption in a business unit… An auditor may be part of the problem. That means embarrassing and costly lack of independence. (Read, “E&Y at Lehman” or “KPMG at Siemens”).
7. You know what Global Network means? It means shifting blame. The audit industry is a profitable $100 billion revenue global business, employing hundreds of thousands of people. The “Global Network” is the legal vehicle the audit industry uses to drive liability around, in the Big 4 version of ”Catch Me If You Can.” Pick a legal entity to sue, any one, all of them and the Big 4 always win because they’re behind the wheel. Each so-called “Member Firm” and the Global Network as a whole is legally insulated from the actions of any other “Member Firm.” Even second-tier accounting firms use this tactic (read, “Grant Thornton and Parmalat”), but the bigger firms have it down to a (legal) science. They’re members and partners until trouble hits. Then, sayonara! Can you say PwC and their problematic Japanese or Russian or Indian – firms?
6. The Big 4 will never again be indicted for an audit failure. Indicting Arthur Andersen proved one thing: All you have to do to destroy a big audit firm is make one criminal indictment. The SEC, the DOJ, even the PCAOB all have acknowledged that they can’t afford the loss of another Big 4 audit firm. Why not? Because they don’t have a plan for ensuring the integrity of financial information for investors if the current model falls apart. And in this environment, who’s going to willingly wipe out 100,000 jobs? The audit firms hold a ”Get Out Of Jail Free” card, and they know it. They don’t fear being indicted. Individuals may be scapegoats (read, “KPMG and their tax partners” or “Flanagan at Deloitte”), but now the Big 4 have as much moral hazard as anyone. Unfortunately, the result is “assurance” provided by walking wounded – firms so severely strained financially and strategically by billions of dollars of pending litigation that their leaders spend most of their time addressing, evading or settling claims instead of improving audit quality.
6.a “Final Four” means no competition and no straight answers. Ask a Big 4 audit partner for a Yes/No answer on valuation, for example, and you won’t get one. There’s only four global firms remaining that have the depth and global breadth to serve the largest multinationals. Each one is working for almost every bank on Wall Street and in The City in some form or another. Independence rules make walking this line a highwire act. If not serving as auditor they’re advising on M&A or internal audit, or internal controls. They may even be implementing new financial systems. For that reason, they’re loathe to criticize anyone or anything and more often will play Switzerland, staying neutral as long as possible, like PwC did between AIG and Goldman Sachs in one of the most notorious disputes of the financial crisis. Better, yet, just keep them out of the loop and everyone will be happy.
5. The auditors have a lock on the business (read, “ratings agencies”). Case in point? Ratings agencies. Both ratings agencies and audit firms have a governmental mandate to provide a legally required service. Both are paid by the clients they rate. And both repeatedly disappoint and even defraud the investing public. They aren’t in bed together, but they willingly endure sleeping with the enemy.
4. Why do the auditors support IFRS and mark-to-market accounting? International Financial Reporting Standards (IFRS) are supposedly on the way for the US, the last big holdout. Forget GAAP’s rules-based guidance, where it’s easier to say an accounting treatment is right or wrong. Principles-based guidance leaves wriggle room and a pretty sure shot at sneaking liability caps for the auditors in through the back door. They’re looking for a “safe harbors” for exercising their “judgment.” And, of course, any approach that causes confusion and complexity is the “next big thing” driving large fees for the firms. Any questions?
3. Campaign candy from K Street. The Big 4 firms spread the wealth on both sides of the aisle in Washington, but the hands out always seem to be the ones with power to effect financial and regulatory reform. Does that reform ever go as far as it should? No. Should it have reached the audit firms at least this time? Absolutely. Did it? No way.
2. Big 4 firms have systematically avoided liability for audit failures. Audit firms are comprised of individuals who become accountants because (a) it’s a path to slow and steady financial success, (b) they’ve an affinity for details, and (c) they tend to be risk-averse. But they also work relatively autonomously, like a thousand franchise owners who are each expected to drive revenues and produce profits. So why are we shocked when (a) they are focused on fees and growing consulting services that make them rich, (b) they quietly but actively lobby for accounting rules that benefit their clients and laws that limit their accountability (read, “PSLRA” and the “Stoneridge” decision, (c) they use accounting rules (read, “special purpose entities,” “off-balance-sheet agreements,” “deferred tax assets,” etc.) to help clients justify almost anything, and (d) they are very good at avoiding liability and painting themselves as “victims” when they “miss” fraudulent activity? Isn’t this what they’re being paid for?
1. AND THE #1 THING TO KNOW ABOUT ACCOUNTING FIRMS…
Lawyers are perceived as part of the problem. Most accounting industry professionals certainly don’t see lawyers as part of the solution. The SEC’s Enforcement Division is comprised principally of attorneys who formerly represented corporations. The audit firms are run by lawyers, internal and external, because they face a crush of litigation. Whether you serve them as defense or plaintiff’s bar, your clients the accountants would rather do their work quietly, collect their money and not be bothered with you. Can regulatory organizations dominated by lawyers not trained in accounting standards or familiar with the history of audit failures, and who have never worked for an audit firm, themselves be watchdogs of the Big 4? Lawyers are trained to advocate for their clients; audit firms have forgotten who their clients really are – the shareholders… Can lawyers influence auditors to do the right thing or has the accounting profession become too suit-shy? Do the SEC’s lawyers have the right attitude to effectively ”guard the guardians”?