Deloitte, Delphi, and GM: Duped or Duplicitous?

By • Nov 21st, 2010 • Category: Latest, Pure Content, The Case Against The Auditors


It’s as wicked as it seems…

What the SEC is doing at Delphi is quite expedient. Merriam-Webster defines expedient as:

1: suitable for achieving a particular end in a given circumstance

2: characterized by concern with what is opportune; especially : governed by self-interest

Expedient usually implies what is immediately advantageous without regard for ethics or consistent principles

Deloitte partner Nick Defazio testified on November 17th in the Securities and Exchange Commission’s civil securities-fraud case against former Delphi CEO J.T. Battenberg III.  Mr. Difazio testified, on behalf of the SEC, that in 2000, Delphi management withheld documents from Deloitte, their auditor, that might have raised red flags about how the company booked a large payment to General Motors, also audited by Deloitte.

The SEC says a $237 million payment by Delphi to GM was to compensate GM for faulty parts. Delphi improperly booked most of it as pension and employee-benefit expenses and avoided an earnings hit, according to Automotive News.

Difazio said that in 2000 he thought the accounting treatment was correct.

“Based on these documents I’ve shown you this morning, … do you believe the accounting for the settlement was correct?” SEC attorney Jan Folena asked.

“I have serious questions about whether it was correct,” Difazio answered. “It appears it was not.”

GM booked the entire $237 million as a warranty payment, which went straight to its bottom line as profit that quarter says the SEC.

Mr. Difazio was sanctioned by the SEC for not doing enough to identify the real purpose of this transaction and others at Delphi.

On February 26, 2008 the Commission instituted two settled administrative proceedings finding that Nicholas Difazio and Duane Higgins, Deloitte & Touche LLP (D&T) engagement partners on the 2000 and 2001 audits of the financial statements of Delphi Corporation, engaged in improper professional conduct on those audits.

In its first Order, the Commission found that Difazio, the lead engagement partner, engaged in improper professional conduct in auditing: (1) Delphi’s improper accrual of an estimated warranty expense by its former parent as a direct charge to equity in the second quarter of 2000, rather than as an expense of the period in accordance with GAAP; (2) Delphi’s improper classification of most of a $237 million payment settling the former parent’s warranty claims to pension and other post-employment benefit “true-up,” causing the amount to be accounted for as prepaid pension cost in the third quarter of 2000 in contravention of GAAP; and (3) Delphi’s failure to account for the fourth quarter 2000 sale of certain batteries and generator cores, coincident with a side agreement to repurchase that inventory, as a financing transaction, as required by GAAP…

In each Order, the Commission found that Difazio and Higgins, among other things, failed to obtain sufficient competent evidential matter to afford a reasonable basis for the opinion rendered by D&T, to exercise due professional care in the planning and performance of the Delphi audit, and in performing the audit to identify material departures from GAAP in the financial statements.

The Commission’s Orders denied Difazio the privilege of appearing or practicing before the Commission, pursuant to Rule 102(e)(1)(ii) of the Commission’s Rules of Practice, with a right to reapply after three years…

Mr. Difazio, although not admitting or denying the charges, consented to the sanction.  He is not eligible for reinstatement to practice before the SEC until at least 2011.

In the meantime, he leads Deloitte’s IFRS initiative.

Yes. That makes a lot of sense. You want a guy who can’t get the GAAP right to advise your company on the impact of converting from GAAP to IFRS and lead new auditors down the path.

How can the SEC allow this? Perhaps Mr. Difazio agreed to testify on behalf of the SEC against Delphi executives to avoid a monetary penalty.

But which is it?  The auditors didn’t do enough?  Or the company hid documents from them?

It seems that the SEC can claim auditors should have known, could have known, and would have known Delphi, with GM’s help, was pulling a fast one if Difazio and his colleagues had, obtained sufficient competent evidential matter to afford a reasonable basis for the opinion rendered by D&T, exercised due professional care in the planning and performance of the Delphi audit, and performed the audit to identify material departures from GAAP in the financial statements.”

But when the SEC wants to bring civil charges for fraud against the company’s executives, the story is that the auditor was duped. That’s because the judges say it’s usually not possible for anyone else to be guilty when company executives do bad things. It’s especially hard when there’s been a bankruptcy.

In December of 2007, Deloitte, as a firm, settled with Delphi investors.

As settlements go, this is relatively minor. However it is another in a long line of settlements rather than trials for Deloitte, whose spokesperson, the hardworking Deb Harrington, always says:

…the company had a strong legal case but “concluded that it was in the best interests of the firm and its clients to settle this matter now rather than face the burden, expense and uncertainty of continued litigation.”

Delphi, you may remember, is one of the Tier 1 automotive suppliers to GM and a close relation of GM, another company with ongoing issues related to poor internal controls. It seems the apples don’t fall far from the trees and poor business practices, bad management and outright fraud were a part of how these companies “made money,” if you can ever believe their numbers.

Deloitte agrees to pay $38 million to ex-Delphi investors

The accounting company Deloitte & Touche has agreed to pay $38.25 million (€26.3 million) as part of a $325 million (€223.9 million) settlement of investor claims of misconduct by Delphi Corp. — the largest auto parts supplier in the U.S. — and those that oversaw its finances.

Delphi filed for bankruptcy protection in 2005, acknowledging that hundreds of millions of dollars in earnings that it had claimed since General Motors Corp. spun it off in 1999 were invalid. A U.S. Securities and Exchange Commission investigation found that Delphi manipulated its earnings from 2000 to 2004, using several illegal schemes to boost its earnings, including the concealment of a $237 million transaction in 2000 with GM involving warranty costs.

Deloitte & Touche, now part of the privately held Deloitte Touche Tohmatsu, served as Delphi’s outside accountant.

“It’s about holding the gatekeepers accountable,” said attorney Stuart Grant of Grant & Eisenhofer, one of four law firms representing public employee pension funds and other Delphi investors in the class action suit.

There’s another interesting aspect to Mr. Difazio’s testimony. Deloitte, as you know, was auditor for both Delphi and GM until the end of 2005. (Delphi switched to Ernst & Young in 2006.  Deloitte remains GM auditor.)  The warranty/pension expense transaction is another example of a transaction treated differently in two public companies audited by the same auditor.  I’ve written about that issue with regard to PwC presiding over the long running dispute between their two clients, AIG and Goldman Sachs, over the valuation of credit default swaps.  I wrote about it again last week in reference to two public companies in litigation with each other and their corresponding litigation disclosures.

The former Delphi General Counsel testified, under oath, that Deloitte, the firm, knew that the two companies were treating the transaction differently and blessed this subterfuge.

“Deloitte & Touche knew intimately what was going on, on both sides of this transaction,” former Delphi general counsel Logan Robinson testified yesterday. “They fully supported it.”

Mr. Difazio rationalizes that.

Difazio said it’s not unusual for two companies to account for the same transaction differently.

Does that sound right to you when we’re talking about GM and its spawn, Delphi?

Delphi and GM have an up close and personal relationship. GM’s audit team probably provides the training ground for Delphi’s audit team.  Both engagement teams belong to the Automotive practice group at Deloitte and operate out of the same geographic area.  Just like in the PwC relationship with AIG and Goldman Sachs, it defies credulity that the team leadership wouldn’t talk to each other and to their industry experts about approach, methodology, and proper GAAP.  In fact, it’s required by their audit methodology and audit risk management policies.

I’ll be writing more about this issue in future posts.

Main photo from this site.

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26 Responses »

  1. Sounds complicated. Maybe they should have gone with BDO. :)

  2. […] This post was mentioned on Twitter by Francine McKenna and rmsnickers, Timothy Connolly CFA. Timothy Connolly CFA said: RT @retheauditors: "It's as wicked as it seems…" My latest blog post: http://bit.ly/dmMiFB #KeefRules $GM […]

  3. The SEC allows this because they are all of the same team. They are all Empty Suits* and they rotate squads – regs go to industry, industry go to regs.

    Here is just one case of both sides of the coin:
    >> http://www.sec.gov/news/press/2010/2010-1.htm
    >> http://www.hedgeyeblog.com/2010/02/08/an-idea-whose-time-has-come-compliance/

    With regards to enforcement, every so often there will be some window dressing to demonstrate independence, but it is only window dressing >> http://www.msnbc.msn.com/id/40284176/ns/business-us_business/

    VD

    *Empty Suit: The physical manifestation of the Dunning-Kruger effect (the illusory superiority of the incompetent) with the additional components of power and authority.

  4. Good artickle, I was considering investing in new GM stock but after reading your article I want nothing to do with this company.

  5. Excellent job explaining a complicated case and one that I use in my accounting ethics class. I would add to your analysis the failure of Deloitte to approach the Delphi audit with professional skepticism. Auditors are taught to apply the “smell test.” There was so much going on during the period that Delphi manipulated its earnings from 2000 to 2004 that Deloitte should have been suspicious enough to extend its audit testing. Moreover, it would seem that Deloitte failed in its effort to assess Delphi’s internal controls. Under auditing standards it should look to the control environment to determine whether Delphi’s culture is one that promotes unethical behavior. Where there’s smoke there usually is fire. A company typically doesn’t engage in one isolated incident of fraud. It’s reasonable to assume others were occurring and Deloitte missed (or looked the other way) in the face of red flags that should have raised questions in its mind about the ethical tone set by top management at Delphi. Undoubtedly, there was a failure in the corporate governance systems at Delphi. So, the cry in this case is not only “Where were the auditors” but “Where were the internal controls, audit committee, and the board of directors?”

  6. @ Ethics Sage

    Thanks for raising the issue of professional skepticism. It’s one of my favorite topics.

  7. Mark, one of the Delphi executives on trial that settled in the last few weeks with the SEC now works for BDO. What is the real deterent if these people are allowed to move on in the same professions?

  8. A few observations: you need to keep in mind that these events occurred during ramp up to sarbanes oxley compliance, but were still in a pre-sarbanes oxley environment. If you check, I believe you will find that Deloitte was heavily involved in an SAP implementation with Delphi at the time. The fees for the SAP work were many multiples of the audit fees (likely 10 times). Of course this is not permitted in a post sarbanes oxley environment.

    The basic model in the US corporate environment is that the external auditors work for the audit committee but the selection process is handled by the CFO and the CFO has a strong influence on whether the external audit firm will continue in their role. Most audit committees want to support the CFO and take their direction on which firm to hire and whether they are doing a good job on an on-going basis. Additionally, the CFO typically has administrative oversight of internal audit and influences both what they look at and who leads it. The dilemma here is that auditors are supposed to evaluate the financials, controls and accuracy of reporting but are largely serving at the pleasure of the CFO, the very person whose organization they are charged with auditing. This, in my opinion, concentrates too much control in one person’s hands and is a conflict of interest. The CFO serves at the pleasure of the president/CEO. This creates opportunity for fraud. Now all that you need is some pressure that will drive them to act on the opportunity. This is not a good formula. In my opinion, if this is not changed, we will see more of this in the future.

  9. Vergil, that article on MSNBC is very scary. It means that (a) regular investors don’t stand a chance in this very uneven playing field, and (b) investors who wish to invest with money managers never really know if the the manager’s model is legitimate or are inflated due to insider trader activity (which means when the manager is busted, the investor will lose their money most likely). Can’t trust anyone in Finance these days. Btw Vergil, just finished the chapter in your book about Empty Suits and loved it, but hit a little close to home being I spent some time in consulting earlier in my career.

  10. […] re: The Auditors » Blog Archive » Deloitte, Delphi, and GM: Duped … […]

  11. […] that business continues as usual in the financial world, I am hopeful when I see others, like Francine McKenna at re: The Auditors also shine the light on the system’s continual abuses aided and abetted by the biggest […]

  12. […] Read this article in its entirety at the re: The Auditors, a blog by Francine McKenna. […]

  13. In training for the CPA exam, I learned that in the 1960s, a woman working for a Big 8 firm (Big 8 at that time) was jailed for accepting “glib” answers from a client who was committing fraud. There was some shock about putting a woman in jail at the time and she was later pardoned. But the expectation at that time was that auditors weren’t supposed to be duped and there might be criminal negligence found if they got duped. Now, it seems that auditors use the “I was duped defense” on a regular basis.

  14. Shouldn’t this issue been raised by Deloitte when it reviewed the reconciliation of the pension account? Wouldn’t it be obvious that the $237 million wasn’t credited by GM to that pension account when Deloitte did that reconciliation? There doesn’t seem to be anything real complex here.

  15. This is a very well written article, and it clearly communicates (once again) the abuse that is prevalent in today’s corporations and the auditors who audit these corporations. However, I would argue that the events presented in this article are not news, but sadly, what appears to be common operating procedure. The over arching theme is that the people in charge (be it the C-suite or the audit partners) are profiting (and not sufficiently punished) for defrauding others. Until the U.S. government actually sets an example, these C-suite executives and audit partners will continue their con and profit as the expense of the American people. The whole audit model is warped – hiring college kids to do all the work, with insufficient review or partner involvement. Please continue to bring these stories to light, Francine. Perhaps one day, the powers that be will actually acknowledge the existence of a problem and do something about it.

  16. Ethics Sage, unfortunately, there is a big discrepancy between what you teach your students and how they are instructed to proceed once employed. The Big 4 generally enter into fixed fee agreements with their clients, and the expectation is that these fixed fee engagements WILL continue year after year. An audit partner, who is usually handed one of these engagements after years of groveling, would be well served not to rock the boat in any way.

    The individuals who actually audit the schedules are likely 1-2 year associates, with perhaps 2-3 year seniors “reviewing” their work. With the current layoffs, many have complained that new associates are effectively “senioring” jobs — meaning that proper review may not even exist. To ensure profitability, the kids are generally put on unrealistic budgets, and they are penalized if they run over budget. Rarely, if ever, is an audit partner (someone with at least 10+ years of experience) actually rolling up his/her sleeves to ensure that the audit is being properly conducted. In fact, an audit partner would be well served to not get too much into the details, so that he/she can claim ignorance upon a future failure.

    The auditing business (in more cases than not) has turned into a bogus money making scheme. Clients are paying for a stamp of approval from the stamp keeper. Companies can buy clean opinions more easily from one firm than another. How convenient for GM and Delphi that they bought their opinions from 1 firm that allowed them to perpetuate the abuse in exchange for $$$. As we have seen, it is pretty easy for an audit firm like Deloitte to buy itself out of trouble and blame the entire incident on one or a few scape goats.

    As someone said in a previous post, it is a bunch of rotating empty suits that perpetuate this abuse, and these empty suits (and their cronies) are allowed to profit at the expense of the American people. It is the same old game.

  17. “As someone said in a previous post, it is a bunch of rotating empty suits that perpetuate this abuse, and these empty suits (and their cronies) are allowed to profit at the expense of the American people. It is the same old game.”

    Absolutely. And, because of their smug knowledge of their “too few to fail” status, Big 4 firms are conducting audits that, if the same inadequate procedures were the basis for a non-Big-4 audit, would get the engagement partner and the firm tarred and feathered by the SEC.

  18. I’ll disagree with Anon above on a few points. It’s really partner by partner on who will roll up there sleeves or not. Most of the newer school partners are too paranoid not to be in every detail. It’s actually quite annoying if you’re a manager or senior manager, as you really see that as your job. But even if the partner is high level, the managers or senior managers are usually well into the details even if the partners are not. It’s not being handled by first year assciates, though there are audit areas that are exclusively handled by senior associates (which have 3+ years of experience vs 2-3 years you reference above).

    I agree with him on others. Namely, the stamp of approval argument. At this point, the firms are so desparate for work, anything will go. It’s not that they don’t do the work, they just find a way to justify the client’s point of view in order to make the client happy. See Allen’s point above. He’s right on.

  19. “Go find issues, not problems”, that was taught again and again implicitly to the staff by partners in big 4….

  20. […] time. Deloitte has not been charged by the SEC in either. I doubt they will be. Deloitte played the “We were duped” card with the SEC and their clients. They sued Flanagan to save face with […]

  21. […] similar to the excuse the auditors use to evade liability for their actions. I call it the, “We were duped,” defense and it’s getting them out of jail free quite a bit these days.  In fact, a little birdie […]

  22. […] done that recently in the Delphi case – played both sides.  Unless I bring it up, no one seems to remember that often auditors concede […]

  23. […] of competence, to testify on behalf of the SEC’s for their case against Delphi executives. Mr. Difazio recently told the court, with a straight face, that his client, Delphi, had deceived him back in the year […]

  24. […] When company executives are guilty of fraud, it’s common for the auditors to claim they have been “duped.” Who wouldn’t agree that unscrupulous, criminal executives could and would seek to “hoodwink” […]

  25. […] Deloitte, Delphi, and GM: Duped or Duplicitious […]

  26. […] common for the accounting firms to keep partners on the payroll while under sanctions with the SEC until they are reinstated. It’s not unreasonable for financial […]

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