I’m surprised there hasn’t been more speculation about who the issuers are in all of Deloitte’s inspections reports. Wouldn’t it be nice if all the issuers in all the inspection reports were disclosed?

Every once and a while someone accuses me of being harder on one firm than another. Typically he/she thinks I’m being too hard on PwC, since I worked there last.  Someone even swore I must have worked for RSM McGladrey given the one or two times I wrote critically about that firm. And there’s a host of folks that think I alternately hate KPMG or Ernst & Young more than the rest.

Deloitte has a special place in my heart. Their office here in Chicago is a really big one. The firm bought my beloved BearingPoint Public Services practice when my employer from my Latin America days went bankrupt. And Deloitte generated probably the most active commenter forums on my blog during their recurring layoffs between 2007-2009.

Right now Deloitte may look like the worst of the Big Four but only because Deloitte is the most publicly incorrigible. That could change at any time. It would be easy to make a case that any of the four largest global firms was on the brink of being put out of their misery, not by an SEC or DOJ charge, but by a preponderance of private legal actions that have become a time and money sinkhole. Deloitte is the current example of a firm – like Ernst & Young is because of Lehman – that’s preoccupied with litigation. They’ve taken their eye off the audit quality ball.

Enron was the catalyst for the U.S. Department of Justice to criminally indict global audit firm Arthur Andersen causing its collapse. But it wasn’t Enron alone that forced DOJ to act. Arthur Andersen made a number of promises to regulators to improve and never sin again that were, over and over, not kept.

In October of 2008, the SEC and FINRA – not Deloitte – caught a Deloitte Vice Chairman trading on insider information in several Fortune 500 clients, including audit clients. Each of those Deloitte audit clients – Berkshire Hathaway among them – was forced to conduct an internal investigation to confirm Deloitte’s independence before Deloitte could continue as the auditor.

The same specific audit engagement criticisms as 2006 show up in subsequent inspection reports for Deloitte’s 2007 and 2008 audits.

• In 2007, application of generally accepted accounting principles and generally accepted auditing standards pertaining to hedge accounting for interest rate swaps, including the failure to identify two related departures from generally accepted accounting principles
• In 2007 and 2008, application of generally accepted accounting principles and generally accepted auditing standards pertaining to the accounting for deferred tax assets, including in one case a failure to identify a departure from generally accepted accounting principles
• In 2008, failure to identify a material weakness in an issuer’s internal controls over its allowance for doubtful accounts

The Deloitte U.S. CEO admitted in its “2010 Advancing Quality Through Transparency Inaugural Report”, that the PCAOB again privately criticized similar quality control issues during inspections of 2007 and 2008 audits. In addition, internal Deloitte reports described more than 475 reprimands to staff and partners in 2009 for infractions such as not following policies regarding auditor independence.

In December of 2010 another Deloitte partner was accused of insider trading.

Many of the audit risk issues described in earlier Deloitte inspection reports show up again in a summary prepared by the PCAOB of its inspectors’ observations during the financial crisis. (The PCAOB says the inspection report for Deloitte’s 2009 audits should be issued by the end of 2011.)

In April of 2011, Navistar – a client for almost 100 years until it fired Deloitte in 2005 – sued Deloitte for fraud, fraudulent concealment, negligent misrepresentations, and professional malpractice amongst other claims. The suit, for 2002-2005 audits, is pending and its merits have not yet been judged. But it raises some interesting issues about the use of the PCAOB’s inspection reports in private litigation, including the non-public portion once it is disclosed.

According to Navistar, the PCAOB selected the company as one of the Deloitte audits to review in 2003 and found several deficiencies. Deloitte audit partners for a Navistar subsidiary,  Christopher Anderson and  Thomas Linden, were sanctioned by the PCAOB. Navistar’s lawsuit claims that Deloitte had a duty to disclose to their audit committee the full scope of what the company says were the PCAOB’s concerns about the auditor’s quality controls. The lawsuit refers to the private portion of Deloitte’s inspection report for 2004 audits.

Why does it take so long for the PCAOB to publish the inspection reports and the public portion of the private report after the firm’s time to respond is up? It’s been five years since the 2006 audits, three years since the inspection report was published, two years since the twelve-month window for Deloitte to make corrections closed.

SEC Rule 104(h)(1), adopted quietly with no comment or press release in the fall of 2010, builds in an additional delay before publishing potentially controversial reports. Although the rule keeps the SEC process private, and the PCAOB is not allowed to discuss whether any particular audit firm appealed to the SEC over its report, the delay allows time for an audit firm to seek SEC redress.

Sources close to the issue tell me Deloitte definitely appealed the PCAOB’s threat to go public.

Keep in mind that while Deloitte bickers with the PCAOB, the audit firm charges hundreds of millions to produce auditor opinions for banks and systemically important companies that were bailed out, forcibly acquired on the brink of failure, or effectively nationalized.

Deloitte was the auditor for Bear Stearns, Merrill Lynch, Washington Mutual, Taylor Bean & Whitaker, American Home, and Beazer. None of these, except Beazer, is still standing. Deloitte has been sued for its audits of all of them.

Deloitte is still the auditor for Fannie Mae, GM and GMAC, and Morgan Stanley. All of these companies received bailouts.

Deloitte also audits the entire Federal Reserve system, and Berkshire Hathaway and BlackRock – two of the major players that supported the recovery of financial system during and after the crisis.

Jim Doty, Chairman of the PCAOB since January, said in a recent speech that the Board was disappointed in the audit firms’ approach to disclosing the results of PCAOB inspection reports to clients. “We hear that auditors are often less than forthcoming with audit committees that try to elicit information about inspection results…”

Here’s a short excerpt from my column on Tuesday at American Banker, “Bankers, Beware An Auditor That Blows Off Its Regulator”.

The PCAOB’s decision to make the 2006 quality control criticisms public, and the fact that the Securities and Exchange Commission allowed it to do so, tell me Deloitte is still fighting the regulators. The deadlines for Deloitte to fix or sufficiently respond to criticisms in the 2007 and 2008 inspection reports have passed. We could soon see previously nonpublic information from those reports, too.

The risk for banks in a situation like this is that an auditor that brazenly irritates its regulator may draw unwanted attention to its clients from their regulators. For example, PCAOB spokeswoman Colleen Brennan reminds me that the SEC knows the names of every company whose audit deficiencies are mentioned in a PCAOB auditor inspection report.

Please read the rest at American Banker.

You may remember earlier this year when The New York Times broke a little story about General Electric’s tax savvyways and the best tax law firm the universe had ever seen (aka the GE tax department).

The report caused more than a few people to get bent out of shape because the Times said GE was enjoying $14.2 billion in profit while “claim[ing] a tax benefit of $3.2 billion.” What that “benefit” really entailed was a mystery but many people jumped to the conclusion that it was a “refund” andProPublica (possibly a little peeved that they got scooped) tried to set the record straight on the Times story.

Despite all the back and forth, everyone was pissed at GE. The company lost aTwitter joust with Henry Blodget and then a bogus press release went out claiming the company was returning the “refund” of $3.2 billion and the Associated Press ran it. Slightly awkward.

Francine McKenna also did a write-up on KPMG’s role in this little soap opera, as the firm has been the auditor for GE since Bill Taft was maxing out the White House bathtub.

The latest twist comes from a tip we received earlier about a “Preservation Notice” sent to all KPMG employees yesterday from the firm’s Office of General Counsel (“OGC”).

URGENT TARGETED PRESERVATION NOTICE: GENERAL ELECTRIC’S LOAN STAFF ARRANGEMENTS

Please be advised that until further notice from KPMG LLP’s (KPMG or firm) Office of General Counsel (OGC), you are hereby directed to take all steps necessary to preserve and protect any and all documents created or received from January 1, 2008 through the date of this Notice relating or referring to the loaning, assignment or secondment of tax or other professionals to General Electric Company and its direct and indirect subsidiaries, affiliates and divisions (collectively “General Electric’s Loan Staff Arrangements”).

Last March, I wrote the story that highlighted this arrangement. The preservation notice refers to tax and “other loaned staff arrangements” so there may be more like this at GE.

Uh oh.

Based on my reading of the rules, loaning, assigning, or seconding tax or any “bookkeeping” staff is not allowed for the auditor. What’s worse is that KPMG had been sanctioned recently for a similar issue in Australia. I guess they thought the SEC/PCAOB would never go after them in the U.S. and never for trying to “please” such a high-profile client.

The Sarbanes-Oxley Act of 2002 started out tough on tax. The rules regarding prohibited activities by the auditor, intended to preserve their independence, scared the living daylights out of the largest firms. It appeared initially that the SEC would prohibit the tax side of the firms from providing highly lucrative tax advice to their audit clients. Many of those professionals started planning an exit from their firms so they could continue working with long time clients.

A compromise was reached. The result is one of the loosest and most generous exceptions to auditor independence rules on the books.

The Commission reiterates its long-standing position that an accounting firm can provide tax services to its audit clients without impairing the firm’s independence. Accordingly, accountants may continue to provide tax services such as tax compliance, tax planning, and tax advice to audit clients, subject to the normal audit committee pre-approval requirements under 2-01(c)(7).

The Sarbanes-Oxley Act of 2002 also prohibits an auditor from providing “bookkeeping” services to its audit clients.

The rules utilize the previous definition of bookkeeping or other services, which focuses on the provision of services involving: (1) maintaining or preparing the audit client’s accounting records, (2) preparing financial statements that are filed with the Commission or the information that forms the basis of financial statements filed with the Commission, or (3) preparing or originating source data underlying the audit client’s financial statements. Our experience with this definition demonstrates that the concept of bookkeeping and other services is well understood in practice.

In defiance of these provisions, KPMG – GE’s auditor – provides “loaned staff” or staff augmentation to GE’s tax department each year. These “temps” perform tasks that would be otherwise the responsibility of GE staff. Sources tell me KPMG employees working in GE tax have GE email addresses, are supervised by GE managers – there is no KPMG manager or partner on premises – and have access to GE employee facilities. They use GE computers because the software required for their tasks is GE proprietary software.

This type of “secondment” to an audit client is never allowed. KPMG should know better. KPMG was recently sanctioned by the SEC for a similar transgression involving their Australian office.

KPMG Australia and at least one other KPMG member firm outside Australia seconded non-tax professional staff to work at each client’s premises, under the supervision and direction of each client, doing the same types of work that each client’s own employees or managers ordinarily would perform, in violation of the prohibition under Rule 201(c)(4)(vi) against “[a]cting, temporarily or permanently, as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client.”

KPMG earns approximately 10% of their total fee from GE for tax services not connected to the audit directly or indirectly. GE’s policies state that these engagements, if for more than $1 million dollars, must be pre-approved by the GE Audit Committee. However, these services should never have been provided at all per SEC independence rules -rules that pre-date Sarbanes-Oxley.

KPMG is well known for supporting, as an auditor, aggressive tax strategies.  Recent controversy over long-time audit client Citigroup’s use of deferred tax assets to pump up its profits is one example.  KPMG also once flew too close to the flame as a tax shelter provider. Its advice to private clients on how to pay less to the IRS almost got the firm taken out of the game completely.

So why, for a measly $8-10 million a year, is KPMG playing with fire in providing these low value, low margin, low status services to GE?  It may be that KPMG wants to hold on to the relationship at any cost.

Read the rest of my original story at Forbes.

Read the rest of the Going Concern story here.

The first column, “Deloitte Blurs The Lines To Court Mutual Funds,” discusses the appointment of SEC and Investment Company Institute alumni Elizabeth Krentzman as that firm’s new head of the U.S. mutual funds practice. Her responsibilities include business development and delivery of audit services as well as tax, financial advisory, and consulting.

Elizabeth Krentzman is a lawyer, not a CPA. She’s worked 11 out of the last 14 years at Deloitte, always on the consulting side of the house. But now auditors are reporting to her.

That’s because this month she got a new job leading Deloitte’s U.S. mutual fund industry practice. She oversees the auditors as well as the tax, financial advisory and consulting staff who serve that industry…

Read the rest here.

I can’t be there tomorrow in person so I thought I would answer a few of the questions for you and for them.

I’ve provided comments to some of the questions below in Bold. I’ve written on these topics many, many times. Instead of repeating those remarks, I’m directing you to some of the most relevant posts.  If you’d like to add your comments please add the appropriate question number for the PCAOB Board.

Ernst & Young Lehman Litigation: It’s No Victory If You’re Going To Trial (Judge Kaplan was damning in his criticism of vague and subjective auditing standards and found it impossible to hold Ernst & Young liable for not complying with them.)

New At Forbes: My Comments On The Latest Sanctions Against Ernst & Young

Going In Circles: A Few Remarks On Audit Reform (On auditor rotation and auditor signing of audit reports.)

The State of Sarbanes-Oxley Compliance: The Protiviti Survey Results

Say Anything: The Big 4 Defense of Overtime Exemptions

McKenna At The Georgia Southern Fraud And Forensic Accounting Conference (With a link to my presentation, “The Skeptical Professional: Requirements and Case Studies”)

Being Expedient: PwC Settles US Class Action

McKenna Speaks At The American Accounting Association Public Interest Section

Not Over Until It’s Over: Price Waterhouse India Settles Satyam (The Satyam case is a classic one regarding auditor independence and auditor skepticism.  Price Waterhouse India demonstrated not much of either.  The PwC US and International firms lack the authority to force them to.  The regulators are not doing anything about this and the courts are impotent, in many cases, to correct this fault.)

Price Waterhouse India Settles With Regulators But Satyam Saga Not Over

Will Auditors Be Held Accountable? The PCAOB Has A Plan

Auditors Abandon Investors On Liability Limits

Auditors Under Pressure In The UK. Or Are They?

Dear PCAOB Board: Your Job Is To Serve And Protect Investors

Top Ten Things Lawyers Should Know About Auditors

Asking The Difficult Questions: An Article About Audit Committees For IIA’s Internal Auditor Magazine

Questions in PCAOB Concept Release on the Auditor’s Report

Content of the Auditor’s Report

Questions

1. Many have suggested that the auditor’s report, and in some cases, the auditor’s role, should be expanded so that it is more relevant and useful to investors and other users of financial statements.

a. Should the Board undertake a standard-setting initiative to consider improvements to the auditor’s reporting model? Yes

Why or why not? Investors pay billions worldwide for an audit report that is universally panned. Investors have been vocal In the UK and in the US regarding the uselessness of the ‘pass/fail” approach to the auditor’s opinion. The current report provides little information about the judgments and decision processes taking place behind the scenes.  Auditors failed during the financial crisis to warn investors of trouble, let alone provide the realistic guaranty of safety for even a limited period of time that shareholders expect.  If this is an “expectations gap” we must close it, either by removing the requirement for an audit opinion from exchange rules – and admitting its futility like the US SEC did with ratings agencies – or improving it so it has a useful purpose for investors. They deserve to get their money’s worth from the effort.

b. In what ways, if any, could the standard auditor’s report or other auditor reporting be improved to provide more relevant and useful information to investors and other users of financial statements? Two places where the current report could be improved are:

1. Development of a clearing house of auditor names attached to public company audit engagements worldwide with their biographies and information about sanctions, suspensions and litigation against them.  I’m not so concerned about seeing a name on a printed report as knowing who is responsible for that audit over time and their qualifications and professional history.

2. The addition of an auditor’s “Disclosure and Analysis” would be priceless. It should be addressed directly to shareholders, not the Audit Committee, and be written in the style of Warren Buffet’s letter to shareholders.  It should state where the auditors and management disagreed and which one prevailed.  It should focus on judgments, estimates, and the range of practices especially regarding interpretation of key accounting standards amongst that issuer’s peer group.

c. Should the Board consider expanding the auditor’s role to provide assurance on matters in addition to the financial statements? If so, in what other areas of financial reporting should auditors provide assurance? Auditors should provide explicit assurance on MD&A. They are already required by standards to communicate with the Audit Committee regarding the adequacy of required disclosures. Interim Auditing Standard AU 380 requires auditors to determine whether all audit-related matters are communicated to the committee:

The auditor’s responsibility under Generally Accepted Auditing Standards (GAAS)

• Significant accounting policies
• Management judgments and accounting estimates
• Audit adjustments
• The auditor’s judgments about the quality of the entity’s accounting principles
• The quality of the management discussion and analysis (MD&A)
• Disagreements with management
• Consultation with other accountants
• Major issues discussed with management before retention
• Difficulties encountered in performing the audit

An Auditor’s Discussion and Analysis should repeat the substance of these communications and highlight where the Audit Committee and/or management disagree with auditors.

2. The standard auditor’s report on the financial statements contains an opinion about whether the financial statements present fairly, in all material respects, the financial condition, results of operations, and cash flows in conformity with the applicable financial reporting framework. This type of approach to the opinion is sometimes referred to as a “pass/fail model.”

a.    Should the auditor’s report retain the pass/fail model? No If so, why?

b.    If not, why not, and what changes are needed? The auditor’s report requires more detailed grading with an explanation of the grades.  Perhaps the grades can be assigned based on whether the failings are individually material or material in aggregate and whether they relate to adherence to standards, aggressive use of estimates and models, lack of disclosure, or poor internal controls.  I am in favor of the separate opinion on internal controls and question a company that could have an adverse opinion on internal controls (material weaknesses) and yet receive a clean opinion on their financial statements.

c.     If the pass/fail model were retained, are there changes to the report or supplemental reporting that would be beneficial? If so, describe such changes or supplemental reporting.

3. Some preparers and audit committee members have indicated that additional information about the company’s financial statements should be provided by them, not the auditor. Who is most appropriate (e.g., management, the audit committee, or the auditor) to provide additional information regarding the company’s financial statements to financial statement users? I am skeptical that most Audit Committees are sufficiently detached and independent of management that communications from them would be any more useful to shareholders.  That is a problem in and of itself.  If auditors were required to provide their own discussion or analysis, they may be reminded of their own need for independence from management.  However, the problem we have, and which is not solved by revisions to the audit report itself, is the problem of auditor independence as long as the auditors are paid by and contract for their services with an Audit Committee controlled by and in service to management.

At the PCAOB’s public meeting in March I heard some object to the auditor providing information to shareholders directly because that might harm the “relationship” between auditors and management.  Yes.  And that is exactly why auditors should be forced to face shareholders directly. Even the SEC’s Chief Accountant and the PCAOB Chairman have admitted auditors are too cozy with management, a non-independent Audit Committee encourages and enables that, and many auditors have forgotten who their true clients are – shareholders.  Auditors should respond directly to shareholders, not to the management-controlled proxy – a potentially non – independent Audit Committee.

4. Some changes to the standard auditor’s report could result in the need for amendments to the report on internal control over financial reporting, as required by Auditing Standard No. 5. If amendments were made to the auditor’s report on internal control over financial reporting, what should they be, and why are they necessary?

We should go back to a separate auditors report on internal controls over financial reporting. If an issuer receives an adverse opinion on internal controls it should be rare or impossible for that issuer to receive any “passing” grade on the financial statements.

Potential Alternatives for Changes to the Auditor’s Report

A. Auditor’s Discussion and Analysis

Questions

5. Should the Board consider an AD&A as an alternative for providing additional information in the auditor’s report? Yes

a. If you support an AD&A as an alternative, provide an explanation as to why. See above 1.b.

b. Do you think an AD&A should comment on the audit, the company’s financial statements or both? Both. Provide an explanation as to why. Should the AD&A comment about any other information? The quality of management’s D&A and any disagreements in that regard over sufficiency or quality of disclosures.

c. Which types of information in an AD&A would be most relevant and useful in making investment decisions? I think information about how the issuer compares in key metrics, disclosures, aggressive interpretation of standards, and use of models and estimates to their peers would be very useful.  In some industries, one auditor has an audit relationship with several major companies, addresses similar issues, evaluates similar approaches and either sees consistent or inconsistent results. This type of discussion and comparison would be very useful to identify outliers and anomalies as well as instances of collusion amongst companies with significant business alliances or who act as counterparties to each other.

d. If you do not support an AD&A as an alternative, explain why.

e. Are there alternatives other than an AD&A where the auditor could comment on the audit, the company’s financial statements, or both? What are they?

6. What types of information should an AD&A include about the audit? What is the appropriate content and level of detail regarding these matters presented in an AD&A (i.e., audit risk, audit procedures and results, and auditor independence)?

7. What types of information should an AD&A include about the auditor’s views on the company’s financial statements based on the audit? What is the appropriate content and level of detail regarding these matters presented in an AD&A (i.e., management’s judgments and estimates, accounting policies and practices, and difficult or contentious issues, including “close calls”)?

8. Should a standard format be required for an AD&A? Why or why not?

9. Some investors suggested that, in addition to audit risk, an AD&A should include a discussion of other risks, such as business risks, strategic risks, or operational risks. Discussion of risks other than audit risk would require an expansion of the auditor’s current responsibilities. What are the potential benefits and shortcomings of including such risks in an AD&A? The auditor is required to be aware of and knowledgeable about these areas per the standards. The auditor must take them into consideration in planning the scope of the audit. I see no additional work to disclose them and to give investors information about how this issuer compares to peer group.

10. How can boilerplate language be avoided in an AD&A while providing consistency among such reports? Regulators should forbid it and enforce accordingly.  All shareholders will, hopefully, start demanding meaningful information.

11. What are the potential benefits and shortcomings of implementing an AD&A?

12. What are your views regarding the potential for an AD&A to present inconsistent or competing information between the auditor and management? I’m not troubled by this.  In fact, I look forward to it. What effect will this have on management’s financial statement presentation? Management will be required to defend it. They should be prepared to do so or to back down.

B. Required and Expanded Use of Emphasis Paragraphs

Questions

13. Would the types of matters described in the illustrative emphasis paragraphs be relevant and useful in making investment decisions? If so, how would they be used?

14. Should the Board consider a requirement to include areas of emphasis in each audit report, together with related key audit procedures?

a. If you support required and expanded emphasis paragraphs as an alternative, provide an explanation as to why.

b. If you do not support required and expanded emphasis paragraphs as an alternative, provide an explanation as to why.

15. What specific information should required and expanded emphasis paragraphs include regarding the audit or the company’s financial statements? What other matters should be required to be included in emphasis paragraphs?

16. What is the appropriate content and level of detail regarding the matters presented in required emphasis paragraphs?

17. How can boilerplate language be avoided in required emphasis paragraphs while providing consistency among such audit reports? 18. What are the potential benefits and shortcomings of implementing required and expanded emphasis paragraphs?

C. Auditor Assurance on Other Information Outside the Financial Statements

Questions

19. Should the Board consider auditor assurance on other information outside the financial statements as an alternative for enhancing the auditor’s reporting model?

a. If you support auditor assurance on other information outside the financial statements as an alternative, provide an explanation as to why.

b. On what information should the auditor provide assurance (e.g., MD&A, earnings releases, non-GAAP information, or other matters)? MD&A, 10Qs.  Auditors should distance themselves from non-GAAP disclosures. Earnings releases should not be inconsistent with 10Qs.

c. What level of assurance would be most appropriate for the auditor to provide on information outside the financial statements?

d. If the auditor were to provide assurance on a portion or portions of the MD&A, what portion or portions would be most appropriate and why?

e. Would auditor reporting on a portion or portions of the MD&A affect the nature of MD&A disclosures? If so, how?

f. Are the requirements in the Board’s attestation standard, AT sec. 701, sufficient to provide the appropriate level of auditor assurance on other information outside the financial statements? If not, what other requirements should be considered?

g. If you do not support auditor assurance on other information outside the financial statements, provide an explanation as to why.

20. What are the potential benefits and shortcomings of implementing auditor assurance on other information outside the financial statements?

D. Clarification of the Standard Auditor’s Report

Questions

21. The concept release presents suggestions on how to clarify the auditor’s report in the following areas:

• Reasonable assurance
• Auditor’s responsibility for fraud
• Auditor’s responsibility for financial statement disclosures
• Management’s responsibility for the preparation of the financial statements
• Auditor’s responsibility for information outside the financial statements
• Auditor independence

a. Do you believe some or all of these clarifications are appropriate? If so, explain which of these clarifications is appropriate? How should the auditor’s report be clarified?

b. Would these potential clarifications serve to enhance the auditor’s report and help readers understand the auditor’s report and the auditor’s responsibilities? Provide an explanation as to why or why not.

c. What other clarifications or improvements to the auditor’s reporting model can be made to better communicate the nature of an audit and the auditor’s responsibilities?

d. What are the implications to the scope of the audit, or the auditor’s responsibilities, resulting from the foregoing clarifications?

22. What are the potential benefits and shortcomings of providing clarifications of the language in the standard auditor’s report?

Questions Related to all Alternatives

23. This concept release presents several alternatives intended to improve auditor communication to the users of financial statements through the auditor’s reporting model. Which alternative is most appropriate and why?

24. Would a combination of the alternatives, or certain elements of the alternatives, be more effective in improving auditor communication than any one of the alternatives alone? What are those combinations of alternatives or elements?

25. What alternatives not mentioned in this concept release should the Board consider?

26. Each of the alternatives presented might require the development of an auditor reporting framework and criteria. What recommendations should the Board consider in developing such auditor reporting framework and related criteria for each of the alternatives?

27. Would financial statement users perceive any of these alternatives as providing a qualified or piecemeal opinion? If so, what steps could the Board take to mitigate the risk of this perception?

28. Do any of the alternatives better convey to the users of the financial statements the auditor’s role in the performance of an audit? Why or why not? Are there other recommendations that could better convey this role?

29. What effect would the various alternatives have on audit quality? What is the basis for your view?

30. Should changes to the auditor’s reporting model considered by the Board apply equally to all audit reports filed with the SEC, including those filed in connection with the financial statements of public companies, investment companies, investment advisers, brokers and dealers, and others? What would be the effects of applying the alternatives discussed in the concept release to the audit reports for such entities? If audit reports related to certain entities should be excluded from one or more of the alternatives, please explain the basis for such an exclusion.

IV. Considerations Related to Changing the Auditor’s Report

A. Effects on Audit Effort

B. Effects on the Auditor’s Relationships

C. Effects on Audit Committee Governance

D. Liability Considerations

E. Confidentiality

Questions

31. This concept release describes certain considerations related to changing the auditor’s report, such as effects on audit effort, effects on the auditor’s relationships, effects on audit committee governance, liability considerations, and confidentiality.

a. Are any of these considerations more important than others? If so, which ones and why?

b. If changes to the auditor’s reporting model increased cost, do you believe the benefits of such changes justify the potential cost? Why or why not?

c. Are there any other considerations related to changing the auditor’s report that this concept release has not addressed? If so, what are these considerations?

d. What requirements and other measures could the PCAOB or others put into place to address the potential effects of these considerations?

32. The concept release discusses the potential effects that providing additional information in the auditor’s report could have on relationships among the auditor, management, and the audit committee. If the auditor were to include in the auditor’s report information regarding the company’s financial statements, what potential effects could that have on the interaction among the auditor, management, and the audit committee?

Making the non-obvious connections between the audit firms and their clients, between the clients and each other, and between the firms and each other is like shooting fish in a barrel. As each new story comes out, especially about the banks, the web of connections and the repeated attempts by desperate executives to move the same deck chairs around on the financial system Titanic are becoming easier to spot.

Sometimes I don’t even have to close my eyes to see the last story where the same guy or the same assets or the same scam is mentioned.

Yesterday it was news of the sale of servicing rights to a gazillion dollars of almost worthless mortgages by Bank of America to Fannie Mae.  Why Fannie Mae?  Because they are so good at using their marketing skills to “conduit” bad paper from the very needy to the less needy.  But is the next guy really a sucker or do they know something we don’t?  When was the last time Fannie Mae assisted the system in this way?  And how do we know it was rotten paper crossing from one bad actor to perhaps another on a government-sponsored bridge built of the taxpayers’ aching backs?

And who is standing on the sidelines watching it all with a wink, a nudge, and a “say no more”?

For the answers to these and other questions, you’ll have to read, “Fool Me Twice: Bank of America Plays Hide and Seek Using Fannie Mae.”

Here’s a teaser:

The last time Fannie Mae got involved in shape-shifting servicing rights to hide fraudulent activity was Taylor Bean Whitaker. That‘s the mortgage originator, audited by Deloitte, that used Fannie Mae’s silence and their influence, according to Bloomberg, to market servicing rights on bad loans to GMAC.

How do we know the most recent $73 billion portfolio might be full of loser loans made via potentially fraudulent means? Fannie Mae told us so when they sued Countrywide, the mortgage originator and source of significant woe Bank of America bought in 2008.

To his credit, Judge Kaplan does leave one important allegation for Ernst & Young to defend:

Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105:

In other words, have plaintiffs sufficiently alleged that E&Y knew enough about Lehman’s use of Repo 105s to “window-dress” its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman?

The answer: yes, in one case.

Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y’s GAAS opinion – the “true sale” opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter.

The “Lee interview” pertains to warnings allegedly made by Matthew Lee, Lehman’s SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman’s board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I’ve been saying for a while that there’s too much deflective focus on the accounting for Repo 105 and not enough on the disclosure.

Now they’ve got a public airing of some dirty laundry by the PCAOB.

From Compliance Week:

The Public Company Accounting Oversight Board has barred the now-former E&Y partner, Peter O’Toole, from associating with a PCAOB-registered firm for three years and fined him $50,000. The board barred the now former senior manager, Darrin G. Estella, from associating with a PCAOB-registered firm for two years. Both auditors can petition the board for reinstatement at the end of their penalty periods. In December, the PCOAB issued an earlier action against Jacqueline Higgins, an E&Y manager, in connection with the same incident.

The PCAOB says the three auditors created, backdated, and added documentation to an audit file when they learned it would soon be inspected by the board. The disciplinary orders say O’Toole was the engagement partner for an audit of an unnamed public company with a Sept. 30, 2009, year-end. The firm gave the company a clean audit opinion on Nov. 23, 2009, then learned the audit would be inspected in April 2010, with inspectors planning to study “securities valuation.”

Ernst & Young spokesman Charlie Perkins tells The Financial Times, “no harm, no foul,” as far as the firm is concerned.

“Our firm’s policy explicitly prohibits persons from supplementing or changing audit workpapers in circumstances like those present here,” said Charles Perkins, a spokesman for Ernst & Young, in a statement.

“When we determined that firm policy had been violated, we subsequently separated the partner and senior manager from the firm. We have co-operated fully with the PCAOB throughout its investigation of this matter. The conduct described in the order had no impact on our audit conclusions or on the client’s financial statements.”

Unless there are sanctions, we won’t know if more of this kind of thing is happening at U.S. firms. That’s becasue that part of the PCAOB inspection report is private.

We do know it’s happening at Ernst & Young in the U.K. Repeatedly.

From my post at Forbes.com, “By Any Means Possible: Auditors Try To Meet Standards By Faking It”:

The latest inspection report for Ernst & Young in the U.K., the same global firm that the PCAOB recently disciplined, cited specific deficiencies: (The AIU inspected thirteen engagements of a total of 295 eligible.)

Signing and dating of audit reports:

On two audits the auditor’s report was signed prior to the completion or evidencing of all necessary review procedures.

Completion of audit disclosure checklists:

…On two of the files that we reviewed it was unclear from the audit file whether the team had re‐performed the completion of the financial statements disclosure checklist.

Audit finalisation:

We found weaknesses in connection with audit finalisation procedures on seven of the audits we reviewed. The majority of these weaknesses related to undetected clerical drafting errors in the accounts including, in one case, an error in the disclosed audit fee.

That is, if there’s not a settlement first.

Yesterday I wrote up my analysis of the decision by Judge Kaplan for my column, “Accounting Watchdog”, at Forbes. In the interest of time and space, I stuck to commenting on the Ernst & Young portion of the decision.

Judge Kaplan dismissed the majority of the allegations against Ernst & Young. The same things auditors are always dismissed for. The only thing that’s new about the judge’s opinion is an indictment of the accounting standards themselves.

The Third Amended Complaint points to several General Standards (“GS”), interpretive Statements on Auditing Standards (“AU”), and Statements of Fieldwork that allegedly are part of GAAS and that E&Y allegedly violated. Many 288 of those standards are couched in rather general and in some cases inherently subjective terms. They require, for example, that the auditor plan the audit engagement properly, use “due professional care,” exercise “professional skepticism,” and “assess the risk of material misstatement due to fraud” – all matters as to which reasonable professionals planning or conducting an audit reasonably and frequently could disagree.

Bearing in mind that E&Y’s GAAS opinion, just like those rendered by all or substantially all accounting firms, is explicitly labeled as just that – an opinion that the audit complied with these broadly stated standards – more is necessary to make out a claim that the statement of opinion was false than a quarrel with whether these standards have been satisfied.

Or is this really news?

Judge Richard Posner during oral arguments in Fehribach v. Ernst & Young LLP, 2007 WL 2033734 (7th Cir. 7/17/07) (pdf),

“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…”

To his credit, Judge Kaplan does leave one important one allegation for Ernst & Young to defend:

Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105:

In other words, have plaintiffs sufficiently alleged that E&Y knew enough about Lehman’s use of Repo 105s to “window-dress” its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman?

The answer: yes, in one case.

Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y’s GAAS opinion – the “true sale” opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter.

The “Lee interview” pertains to warnings allegedly made by Matthew Lee, Lehman’s SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman’s board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I’ve been saying for a while that there’s too much deflective focus on the accounting for Repo 105 and not enough on the disclosure. And I took particular exception early on to Ernst & Young’s handling of the Matthew Lee “whistleblower” situation:

Ernst & Young failed to follow professional standards of care with respect to communications with Lehman’s Audit Committee.

Ernst & Young failed to follow professional standards of care with respect to an investigation of a whistleblower claim

Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. (Bankruptcy Examiner’s Report V3 page 945)

As the lawyers would say, the optics are bad here. The Audit Committee asks EY to support Lehman’s internal auditor in investigating a “whistleblower’s” allegations of balance sheet improprieties.  The auditors interview the “whistleblower” and then don’t say anything at any of the Audit Committee meetings. Turns out what Mr. Lee, the “whistleblower”, was alleging is what the examiner believes is the fundamental problem and grounds for “colorable claims” against top officers and EY.

The word “whistleblower” is tainted with tons of emotion post-Enron. We now look at those called “whistleblowers” and see heroes. But let’s look at what I think may have actually happened. Lehman’s Internal Audit department “naturally” asked their trusted, all-things-to-all-people advisor, EY, to help with the investigation of the “whistleblower’s” claims. The Internal Audit Department, not EY, was in charge of the investigation.

That was their first mistake. If I’ve said it once, I’ve said it a thousand times: The external auditor should not be conducting or assisting with internal investigations of potential fraud or illegal acts by top executives. I wrote about it atSiemens, subject of the largest ever FCPA settlement in history. KPMG, their auditor, got sued.

The external auditor should stay the hell away from internal investigations because they may get caught up in something they would rather not know. They may want to claim plausible deniability. And a company should not engage the external auditor to support internal investigations especially involving fraud or illegal acts by top management. Do they do it to be cheap or to keep dirty laundry inside? The external auditor is too often part of the problem, an enabler, instead of part of the solution.

If Lehman had hired another firm – a law firm or anyone except their external auditor – to perform the investigation, the investigation would have been covered end to end in privilege, the external auditor may or may not (in this case EY would have been better not to) have been included in the “circle of privilege,”  and the investigation would have been completed professionally.

However, by supporting this investigation, EY was essentially doing internal audit work, a prohibited service under Sarbanes-Oxley for independence reasons. It’s shocking to me that the EY audit partners did not at least turn over the investigation to EY’s Forensic Accounting and Investigations Practice in order to provide some semblance of independence and professionalism.

Even though EY may have been an unwilling party to knowledge of an ugly situation right before an audit committee meeting, they got stuck. They had an obligation under AU 380, as the external auditor  - not as an investigator – to inform the Audit Committee. They could have been on the other side being informed – or not – instead of being the one supposed to be doing the informing.

AU 380, the  rules for auditor communication with the Audit Committee, are very clear. But they relate to the auditors’ role as an auditor not the role  of an auditor who is lent as muscle to an internal investigation. By playing the “trusted advisor” they screwed themselves.

Stoplight?  Yellow. Looks bad, but EY may be able to talk their way out of this one once it gets to court. They need to explain how they were still looking into the issue, doing their “auditor” work and make sure their full but limited role and responsibilities for the process are explained. If they lose on this chalk it up to another case of audit partners wanting to be supermen to their clients, the corporation’s executives, rather than looking out for their own best interests. Unfortunately in this situation, the shareholders were probably going to lose either way.

For a few dollars more…  Or, more likely, no additional fee for helping with the internal investigation, Ernst & Young got stuck. Unfortunately, Berkshire Hathaway ignored this lesson in the Sokol case. They used a non-independent attorney and his law firm to investigate Sokol’s suspicious Lubrizol trades. And News Corp. is ignoring it, too. They also are using insiders to investigate the phone hacking allegations.

Despite what some columnists are saying…

Floyd Norris, The New York Times, July 28, 2011:

The company misled investors and its officers and directors may be held liable. But the company’s auditor seems likely to escape any responsibility for an audit that wrongly concluded the company’s financial statements were completely proper. That, anyway, is the conclusion a federal judge has reached regarding Lehman Brothers. The judge said this week that it appeared Lehman had violated Generally Accepted Accounting Principles, or GAAP, even if it was in technical compliance with accounting rules. But he threw out a claim against Ernst & Young, whose 2007 audit certified that Lehman had followed GAAP.

…I believe Ernst & Young has not escaped anything. Here’s what I emailed Lynn Turner, former Chief Accountant at the SEC, after he circulated Norris’ column to his newsletter subscribers:

They are on the hook for something, it allows discovery, and this is not the only case against them.

This Lehman suit over a securities offering is not Ernst & Young’s biggest worry. They are a bit player. The New York Attorney General’s case against them, the one about fraud, is where they star.

Nevertheless, this dangling allegation is serious – scienter regarding their client’s deliberate material misstatement of a quarterly financial statement filing and public disclosure.

Here’s an excerpt from what I wrote on March 31, 2010 after the Lehman Bankruptcy Examiner’s report came out and EY defended itself with a letter to Audit Committee members:

EY: General Comments

EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008.

Although technically correct, EY is not yet off the hook. In fact, EY did something that seems odd to me – issue an actual report of their review of the 10Qs in 2008 that were included in Lehman’s regulatory filings. I credit Jonathan Weil of Bloomberg for bringing this potential Achilles’ heel in EY’s defense to my attention. However, he incorrectly used the term “opinion” in his most recent commentary to refer to EY’s reports of their review that were included in Lehman’s 10Q’s. It’s an oddity that investment banks insist on a report for the 10Q review from their audit firms. A review is required. A report is not. I still don’t know why Lehman requested  reports to be included in quarterly filings. I certainly can’t, for the life of me, figure out why the auditors would do it.

Post- Private Securities Litigation Reform Act, auditors (and law firms) have escaped liabilities for misstatements in quarterly reports because they do not make “explicit” statements. That is, their review is done in the background, they provide no written report and their review is not technically, or in their opinion, an “opinion.”

But providing an actual report of the 10Q review, one that is included in the regulatory filing, may be what opens EY to liability for Lehman’s 2008 financials. Auditors also provide reports documenting their 10Q reviews for Goldman Sachs (PwC) and Morgan Stanley (Deloitte).

Deloitte also provided reports of their 10Q reviews for Merrill Lynch prior to their absorption by Bank of America and for Bear Stearns prior to their bankruptcy and absorption into JPM Chase. The auditor’s report of their review for Bear Stearns’ 10Q as of February 28, 2008 actually had a “going concern” warning. Bear Stearns agreed to be bought by JPM Chase in early March.That was crucial but too little too late. The actual 10Q was not issued until April, after the JPM purchase had been proposed.

Notably, EY does not provide these reports of their review of 10Qs for UBS, PwC does not do this for JPM Chase or Bank of America, and KPMG does not do so for Citigroup.

Cases such as Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 154 (2d Cir. 2007) make it clear that an explicit statement by the auditors is necessary to hold them liable. I have not been able to find any cases where auditor reports of their 10Q reviews made the difference in auditor liability. It may difficult to find case like this since so many complaints of malpractice against the auditors settle rather than go to trial. I have the distinct impression Jonathan Weil thinks that provision of a report of the auditor’s 10Q review may strengthen the possibility of liability for EY.

I agree, but recognize I have nothing but hope to base this conclusion on.

In addition to the New York Attorney General’s case against Ernst & Young, they still have to worry about the SEC and Department of Justice. Serious sanctions against Ernst and Young by the SEC, or criminal charges from the Department of Justice for Lehman executives possibly fraudulent Section 302 certifications, are unlikely. However, the SEC and PCAOB would be remiss if they did not eventually sanction some individuals at least, if not the firm as a whole.

What I wrote October 31, 2010:

Ernst & Young, take my word for it, will never be indicted by the U.S. government, as a firm, for its role in any Lehman fraud that’s eventually proven. It’s also highly unlikely – 1000 to 1 odds I’d say – EY will be fined by the SEC or the PCAOB, as a firm, in a civil or disciplinary case.

The Ernst & Young partners named in the bankruptcy examiner’s report, and maybe a national practice partner, might be sanctioned by the PCAOB or SEC. Later. Much later. We can predict the timing based on the SEC’s handling of the Bally’s sanctions. Even with a slam dunk case, the SEC waited six years before they settled with EY.  The eventual sanctions against six Ernst & Young partners for the Bally’s fraud were too little and much too late to provide a deterrent or any real justice.

Ernst & Young, as a firm, and their individual partners are named as additional defendants in private lawsuits against Lehman executives. But the New York Court of Appeals, in a 4-3 opinion, refused to hold the auditors responsible for their role in frauds perpetrated by management in the Kirschner (Refco Trustee) v. KPMG and Teachers’ Retirement v. PwC (re: AIG 2002-2005 fraud) cases. The opinion reaffirmed the application of the in pari delicto doctrine and the principle of imputation in these cases.

The judges who disagreed with the majority opinion said it best:

These simplistic agency principles as applied by the majority serve to effectively immunize auditors and other outside professionals from liability wherever any corporate insider engages in fraud…it is unclear how immunizing gatekeeper professionals, as the majority has effectively done, actually incentivizes corporate principals to better monitor insider agents. Indeed, it seems that strict imputation rules merely invite gatekeeper professionals “to neglect their duty to ferret out fraud by corporate insiders because even if they are negligent, there will be no damages assessed against them for their malfeasance”

The more successful a fraud case is against Lehman’s executives, the less likely EY or any of its partners will suffer any consequences for their acquiescence to or complicity in the fraud. That’s not to say the firm won’t suffer slowly and painfully from the enormous amount of time and money devoted to defending themselves in Lehman litigation and the rest of the suits they face.

Don’t get me wrong.

I’m thrilled that there’s a lot of traffic in my lane. What I mean is, it’s good for everyone that we’re talking about these issues and that someone other than me and a few other broken records are playing these tunes.

Fairly new PCAOB Chairman Jim Doty and his fellow board members have been on the road constantly since the three newest members – Doty, Ferguson and Hanson – took their seats in February. And they’re not letting up on the auditors and their firms.

Every speech is laced with lessons, examples, and promises of more to come.

Some key areas of focus:

• Reform of the audit reporting model
• Erasing gaps in international inspection coverage especially U.K., E.U., and China
• Response to the Chinese reverse merger frauds
• Audit quality and professional skepticism
• Auditor independence
• Greater transparency of PCAOB activities especially sanctions and disciplinary activities

There’s been significant activity in many of these areas. In fact, Board member Lew Ferguson is currently in China with representatives of the SEC to discuss opening up that country to PCAOB inspectors.

But whenever talk of audit industry reform comes up, usually after the latest accounting scandal or major fraud, the same old suggestions come up again, too.

The global financial crisis set in motion, again, the soul searching that occurs every ten years or so in the audit industry. It’s been almost ten years since the Enron scandal bred the Sarbanes-Oxley legislation that was supposed to be the “be all end all” for auditor failures and to prevent frauds and failures of all kinds.

But, of course, this wasn’t the case.

Before that the U.S. had a savings and loan crisis and, before that, other crises of confidence in the profession sparked by individual malpractice cases or fraud and corruption where the auditors either missed the problem or, worse yet, were complicit in it.

The auditors’ role in the latest crisis is only recently being examined. I’ve been pushing hard for that since 2007 when we started to see the subprime crisis and the failures of mortgage originators and home builders. The subprime crisis turned into a credit crisis which turned into a full blown financial crisis and recession or depression depending on which country you live in and your personal circumstances.

I think the turning point in attitudes towards this crisis, and the auditors’ role in particular, was the Lehman bankruptcy examiner’s report in March 2010. This was the first time the issue of fraud was raised relative to major failures that precipitated the financial crisis and, specifically, with regard to the auditors. In the Lehman case it’s Ernst & Young.

Until then, most media accepted the bankers’ and government’s version that the end of 2008 was a black swan economic calamity of unpredictable and unprecedented proportions that no one could have prevented.

But even that didn’t really turn the tide completely for the auditors. Critics in the UK started asking the question, “Where were the auditors?” much sooner than anyone in the mainstream media in the U.S..

U.S. regulators began to take notice when Big Four audit industry leadership claimed, in testimony in the House of Lords in November of 2010, to have been ordered to stand down and not issue going concern warnings on the major banks that failed and were nationalized. In response, the PCAOB’s Investor Advisory Group (IAG) raised the issue of the auditors’ role in the crisis and requested deeper study. It remains to be seen if that study will be completed by the IAG or another group, but just the fact the issue was raised, and so pungently by so many, meant that the auditors’ “good crisis” was, perhaps, over.

The PCAOB, at least, has taken up the challenge of responding to investors’ concerns about the value of the audit report, the role of the audit industry in the crisis and the profession’s role in preventing another one. The audit report itself, in spite of the profound changes in the business environment, has changed very little in the last forty years. In the meantime, frauds, Ponzi schemes, business failures and various other financial calamities continue to occur all over the world with increasing frequency and little or no warning from the auditors. The PCAOB has issued a Concept Release on the subject and is expecting comments from all fronts.

A few other reforms are less dramatic but equally likely to elicit strong feelings on all sides.

Auditor rotation is a suggestion that comes up over and over with no resolution. The Financial Times’ Agenda (subscription only) explored the pros and cons of the issue. I was quoted and so were a few other notables such as Denny Beresford, who currently chairs the Audit Committees at Fannie Mae and Legg Mason.

I get the last word with this quote:

But even Francine McKenna, an outspoken critic of the industry, does not advocate mandatory term limits. “In a perfect world, if we had enough firms and if we had enough capacity and ability to go around, then it would be a wonderful idea,” she says. “But I think, practically speaking, it would make things worse. Trading one potentially corruptible firm for another potentially corruptible firm doesn’t really help.”

Instead, McKenna advocates radically changing the industry structure. “My personal feeling is we’re not going to get a good audit until we take it out of the companies’ hands and put it into the hands of an agency that controls the fees and controls who does the work,” she says. “You can’t have companies paying for audit firms directly.”

Another perennial favorite audit reform straw man is audit partner signatures on audit reports. I wrote a column about it at Forbes.com this week.

As usual, I think the proposals never go far enough – more likely a feature rather than a bug  - and that’s why they end up spinning, eventually, down the drain.

The PCAOB approved Auditing Standard No. 7, Engagement Quality Review on July 28, 2009. They also issued a Concept Release on requiring the engagement partner to sign the audit report.

The suggestion was not a new one. On October 14, 2009, the PCAOB’s Standing Advisory Group (SAG) discussed the concept release and the comments that were received.

Auditors have traditionally opposed individual partner signatures for audit reports arguing the engagement partner is already known to the client audit committees and partners already hold themselves accountable to their own own high standards of professionalism and accountability. Those professional standards are supplemented by mechanisms that are in place to allow third parties to hold them accountable.

Like lawsuits.

The comment period closed September 11, 2009 and boy oh boy were there a lot of comments. The audit firms arrived en masse to denounce the proposal. Jim Hamilton’s World of Securities Regulation had a great summary of their arguments.

Whenever there’s talk again of reforms, the audit industry uses fear of catastrophic liability and higher fees to inure alignment with their clients – rather than shareholders the auditors view the public company executives who hire them as their client – and to scare everyone else into leaving sleeping dogs lie.

When discussion of these reforms started to gain momentum in the U.K. earlier last year, the first thing out of the industry’s mealy mouths was liability caps. I suppose worrying about no moral compass is moot if there’s moral hazard.

The Standing Advisory Group (SAG) discussion of the concept release in October 2009 highlighted that previous panels and studies had raised the suggestion before, the objections were always the same, and nothing ever came of it. The SEC put together a group in 2008 to streamline financial reporting that touched on audit industry issues. The Treasury’s Advisory Committee on the Auditing Profession (ACAP), a panel formed after the Enron scandal, also delivered recommendations in early 2008.

Gaylen Hansen: During the Treasury Committee proceedings and the testimony, the investors felt very, very strongly about this…We’ve been over these arguments. I didn’t hear any new arguments in the comment letters that we’ve heard during the testimony that came before ACAP or in the discussion that we had last year, or maybe it was the last SAG meeting, on this particular issue. But we’ve been doing what we have for the last hundred years…

The Concept Release on Requiring the Engagement Partner to Sign the Audit Report is still on the PCAOB standards setting docket. No further public action has been taken on it since 2009.

Please go to the Forbes.com article, “Auditors and Audit Reports: Is The Firms’ ‘John Hancock’ Enough?” for my suggestion.

Hint: It’s something like what they do with sex-offenders.

Main page photo courtesy of The Guardian UK.

Thank goodness for the plaintiffs’ bar and class action lawsuits.

And state attorneys general.

Without them, there’d be very little justice yet – or compensation – for any of the mortgage-related fraud perpetrated during the recent real estate bubble.

Chad Johnson, a partner in the litigation practice at Bernstein Litowitz Berger & Grossmann LLP, posted in the Harvard Law School Corporate Governance and Financial Regulation Forum (on behalf of colleague Ross Shikowitz who wrote the article) that private litigants, in spite of some significant impediments, are picking up the slack for the SEC and Department of Justice.

Now, more than ever, private lawsuits are needed to supplement the existing regulatory structure, both to ensure that shareholders are adequately compensated for their losses and to send a strong message that fraudulent conduct will not be tolerated. Indeed, institutional investors continue to vigorously prosecute suits against the companies and executives at the heart of the mortgage crisis, well after the SEC and DOJ have shuttered their civil and criminal investigations.

While it remains to be seen whether government regulators will eventually force Wall Street executives to answer for their improprieties, it is clear that sophisticated public pension funds will continue to play an essential role in obtaining compensation for injured investors and deterring future wrongdoing by corporate executives.

Even when institutional investors like pension funds try to work within the system, using their significant, long-term shareholder standing to exert influence on corporate boards, they have been turned back. The banks and financial institutions won’t own up to their mistakes and their executives to their culpability willingly.

Eliot Spitzer explains the phenomenon in his recent broadside, “Government’s Place In The Market,” published by Boston Review Books and MIT Press.

“Only government can ensure integrity, transparency, and fair dealing…even though private companies compete, only government can ensure that there is competition. Everyone wants to be a monopolist.”

In January, my column, Accounting Watchdog, described the potential impact on bank stocks of a letter sent to Bank of America, Citigroup, JP Morgan Chase, and Wells Fargo by New York City Comptroller John Liu. This letter, sent on behalf of a coalition of seven major public pension systems, called on the banks’ Audit Committees to launch independent examinations of their loan modification, foreclosure, and securitization policies and procedures.

Liu had proposed these reviews, initially on behalf of the New York City pension plans, back in November. The banks were cold to these proposals, as well as the one in January by the larger coalition. The pension funds called for immediate action.

Time passed with no willingness by the banks’ boards, in particular their Audit Committees, to conduct independent reviews in the normal course of business. So, the coalition submitted shareholder proposals for the banks’ annual meetings. Throughout this period, the boards of the four banks were generally unresponsive to the coalition’s requests to discuss and meet on the proposals. Audit Committee members would not meet with them at all.

It’s a sign of the banks’ unwillingness to own up to the problems we know so much more about now that the only way for these institutional, long-term investors to be heard was to submit an advisory-only  shareholder proposal viewed as antagonistic by the banks’ boards.

“The banks and financial institutions won’t own up to their mistakes and their executives to their culpability willingly.” Chad Johnson

I said at the time that the letter didn’t go far enough. The reviews should also have demanded an accounting of the reserves for loan losses and for litigation. These numbers have been slow to come and, when they did, hard to decipher.

Gretchen Morgenson in the New York Times on January 8: While it is unfortunate that the Bank of America deal won’t recoup much for taxpayers, the resolution could have one important benefit. It might just open the door to a much-needed reckoning of the liabilities created by questionable mortgage practices at the nation’s largest banks. These institutions have not yet made a full and realistic accounting of their liabilities.

I agree.

On September 30, 2010, before the SEC issued its letter to bank CFOs reminding them to follow the standards and book adequate reserves, I wrote that Bank of America had admitted it had “repurchased, during 2009, $13.1 billion of loans from first lien securitization trusts as a result of modifications, loan delinquencies or optional clean-up calls.”

I couldn’t easily see what the actual reserves were for estimated future liabilities and how they came up with a number given the total loans sold by type and the current claims by various parties. I said it’s time for someone, perhaps the SEC, to demand more detailed disclosure about reserves for repurchase risk.

When I challenged the SEC to push harder on the reserves issue they stepped up. But disclosures are still not complete.

Here’s an excerpt from the New York City Comptroller’s shareholder proposal that did appear in the Bank of America proxy document dated March 30, 2011:

…Resolved, shareholders request that the Board have its Audit Committee conduct an independent review of the Company’s internal controls related to loan modifications, foreclosures and securitizations, and report to shareholders, at reasonable cost and omitting proprietary information, its findings and recommendations by September 30, 2011.

The report should evaluate (a) the Company’s compliance with (i) applicable laws and regulations and (ii) its own policies and procedures; (b) whether management has allocated a sufficient number of trained staff; and (c) policies and procedures to address potential financial incentives to foreclose when other options may be more consistent with the Company’s long-term interests.

Board’s Response to Proposal 7

The Board recommends a vote AGAINST Proposal 7 for the following reasons:

• our company has already taken significant steps to ensure that appropriate internal controls are in place, including additional controls and processes we have implemented following a comprehensive self-assessment of our foreclosure processes, as well as an environment of heightened regulatory scrutiny by state and federal authorities, including certain bank supervisory authorities ;

• we actively manage the loan modification and foreclosure processes to ensure that we have strong internal controls over our mortgage service operations;

• we have been a leader in providing foreclosure alternatives, assisting homeowners and constituent groups to resolve home loan issues through loan modifications or other solutions where possible; and

• our company has already provided extensive public disclosure regarding the requested information, which makes the report sought by the proposal unnecessary.

In each case where the Comptroller’s shareholder proposal made it to an April Annual Meeting agenda, management recommended a “no” vote for the proposal.

The proposals all failed to gain a majority vote.

At Bank of America, the shareholder proposal gained a strong 40% “yes” vote. At Citigroup, the “yes” vote was just shy of 30% and at Wells Fargo a little less than 23%. At JP Morgan Chase the coalition’s proposal did not make the Annual Meeting Agenda because a similar proposal, according to the JPM Chase Board, was in line ahead of theirs.

Michael Garland, Executive Director for Corporate Governance for the New York City Comptroller, told me that his office will continue to press for the independent reviews. These reviews, the Comptroller insists, should not be performed by the banks’ auditors since, “we do not consider the existing audit firm to be independent since they previously signed off on the internal controls.”

New York City Comptroller John Liu: “ Our pension funds are long-term investors. We’re going to be around a lot longer than any of the management or the board members of these banks. As shareholders we will continue to insist bank boards clean house until we see independent audits of their mortgage and foreclosure practices.”

Other interested parties have been pressing since the spring of 2011 for reviews of, and changes and improvements to, the banks’ policies, procedures, and processes around loan modifications, foreclosures, and securitizations. There have also been several calls for more transparency, and honesty, in the banks’ allocations of reserves for loan losses and litigation.

On May 12, FDIC Chairman Sheila Bair testified before the Committee on Banking, Housing, and Urban Affairs of U.S. Senate:

Serious weaknesses identified with mortgage servicing and foreclosure documentation have introduced further uncertainty into an already fragile market.The FDIC is especially concerned about a number of related problems with servicing and foreclosure documentation. “Robo-signing” is the use of highly-automated processes by some large servicers to generate affidavits in the foreclosure process without the affiant having thoroughly reviewed facts contained in the affidavit or having the affiant’s signature witnessed in accordance with state laws.

The other problem involves some servicers’ inability to establish their legal standing to foreclose, since under current industry practices, they may not be in possession of the necessary documentation required under State law. These are not really separate issues; they are simply the most visible of a host of related problems that we continue to see, and that have been discussed in testimony to this Committee over the past several years…

Our examiners participated with other regulators in horizontal reviews of these servicers, as well as two companies that facilitate the loan securitization process. In these reviews, federal regulators cited “pervasive” misconduct in foreclosures and significant weaknesses in mortgage servicing processes. Unfortunately, the horizontal review only looked at processing issues. Since the focus was so narrow, we do not yet really know the full extent of the problem.

In April 2011, the Office of the Comptroller of the Currency (OCC), the Federal Reserve Bank (Fed), and the Office of Thrift Supervision (OTS)  - the IndyMac regulator – ordered fourteen large mortgage servicers to overhaul their mortgage-servicing processes and controls, and to compensate borrowers harmed financially by wrongdoing or negligence.

An article in Thomson Reuters’ News and Insight on May 19 describes the problems some were having with the setup of this Consent Order, specifically the way the “independent” reviews required by the Order were expected to be performed.

U.S. regulators are pinning their hopes on independent consultants picked by large U.S. banks to uncover the true depth of foreclosure misconduct seen at lenders. Regulators are close to signing off on these consultants, which are expected to include Promontory Financial Group, Treliant Risk Advisors and PricewaterhouseCoopers…

The key thing is that the independent consultant needs to recognize that the client is the regulators… and not the bank,” said Joe Evers, a large bank deputy comptroller at the OCC. “They need to be taking direction from us and they need to be meeting our expectations.”…

One issue is who would do the review if not the consulting firms. Regulators say they don’t have the manpower, and so they are looking for firms with the required expertise. Senator Reed suggested the regulators at least hire the firms directly rather than approve the banks’ choices. Evers said regulators decided not to take this approach because it would have raised government contracting issues that could have slowed when the reviews begin. He said the agency also has had success using third party reviews in past enforcement actions.

The problem with this approach and the inherent conflicts of interest should be obvious to all but the most naïve observers.

It’s a joke for any government agency, especially one says they’re in the enforcement versus the supervision business, to defend an approach that allows the entity found guilty of wrongdoing to select the consulting firm that tells them how bad they were and how much they have to pay for the bad behavior.

It’s not like the agencies – Treasury, the General Accounting Office, the Federal Reserve, the SEC, and others like them – don’t have procurement teams that contract with professional services firms on a direct basis all the time. One only has to look at the assistance that all the Big four audit firms  - and lawyers and other consultants – provide to the Federal Reserve Bank, The SEC and the Treasury on the TARP program and related initiatives as a result of the crisis. The process, controls, and the rationale for direct contracting is already in place.

And let me assure OCC spokesperson Evers that audit firms like PwC will not look at the regulators as their clients instead of the banks unless someone makes them. They know where their bread is buttered and where their next meal is coming from.

The SEC and the PCAOB, the audit industry regulator, have said so.

The reforms from early this decade notwithstanding, I believe more can and should be done to emphasize the importance of independence and the auditor’s duty to shareholders and the public. It is integral to the foundation of the reason for requiring an audit in the first instance…I’m not suggesting that the role of an auditor should be that of an adversary; but it also cannot be, either in fact or in appearance, that of an advocate for the management of the company it audits. In a world where the mantra “the client is always right” can be typed in to Google and return over 8 million results in .30 seconds, I would suggest it is time to give serious consideration to changing the perceived “client” in audit relationships.

Auditors are, after all, paid by the clients they are charged with policing. As in other professions, auditors want to advance in their chosen profession which often means keeping the client happy and growing their business.

Auditor independence requirements serve as counterweights to those forces. One example of those counterweights may be found in the SEC rule that says an accountant will not be considered to have the necessary independence from its audit client if an audit partner earns or receives compensation based on selling non-audit services to the audit client. The purpose of this rule is to keep auditors singularly focused on the quality of their audits and not on nurturing a relationship that will make management more receptive to cross-selling efforts.

Despite those requirements, PCAOB inspection reviews of partner evaluation and compensation processes find examples of seemingly unrestrained enthusiasm — in partners’ self-evaluations, in their supervisors’ evaluations of their performance, and in agreed performance goals — for selling services to audit clients…We don’t see these problems in all the files we look at, but we have seen them in sufficient number to raise troubling questions, not the least of which are whether these audit partners are unaware of, or simply unconcerned about, the independence rule that should make such considerations irrelevant to their compensation, and why a firm would allow such unawareness or unconcern to continue unabated.

So let’s look at the proposed consulting firms. Promontory Financial Group, Treliant Risk Advisors and PricewaterhouseCoopers are professional services firms that serve the large banks directly on other consulting assignments.

The banks that must be reviewed are their existing or target clients.

PricewaterhouseCoopers (PwC) is the auditor of two of the banks that must be reviewed – Bank of America and JP Morgan Chase. That’s an independence conflict that can’t be overcome. PwC can not be involved in the reviews at these banks. Recently, retired PricewaterhouseCoopers’ Chairman Sam DiPiazza joined Citigroup as a Vice Chairman in the Institutional Clients Group and a member of the bank’s strategic advisory board. There’s another conflict for PricewaterhouseCoopers.

Where PwC is not serving a bank as auditor - namely Citigroup and Wells Fargo - they are already serving as a consultant. These three consulting firms want consulting business from these banks, now and in the future. If PwC is allowed to participate in reviews at Bank of America and JP Morgan Chase, PwC’s will seek to protect their audit relationships and avoid highlighting their own or their clients’ serious errors.

PwC will also seek to protect their fellow Big Four audit firm – KPMG – which audits Citigroup and Wells Fargo, owner of Wachovia one of the large mortgage originators. Although each audit firm has their own level of tolerance for client’s bad behavior and for accepting clients’ “judgments and estimates” there’s a least common denominator bottom line that keeps all the firms in line at all their large financial services clients.

As we saw during the crisis, any one of the Big Four auditors could at any time, by virtue of failure, acquisition, or merger, become the auditor of any of their fellow firm’s clients. No firm wants to inherit a client that’s too far out on the edge. As a result the largest firms are all as good – and as bad  – as each other in enforcing the standards in the most controversial areas.

In addition, given the firms’ self-insured status using a captive offshore vehicle that all the largest firms participate in, litigation against one audit firm as a result of finding mortgage fraud at their client hurts them all – in the pocketbook as well as reputationally.

The plans for independent reviews required by the banks’ Consent Order with the OCC, OTS, and the Fed are due July 13. Additional self-assessments were orderd for all banks, not just those under the consent decree.  Those are due September 30. According to HousingWire’s Jon Prior, the reports of the reviews will not be made public. Would it be possible keep the reports secret if the regulators had contracted for the reviews directly?

I think not.

On June 13, the Huffington Post’s Shahien Nasiripour disclosed that New York State Attorney General Eric Schneiderman had turned up the heat on Bank of America and other banks, servicers, and trustees of the mortgages that were securitized.

New York Attorney General Eric Schneiderman has targeted Bank of America, the biggest U.S. bank by assets, in a new probe that questions the validity of potentially thousands of mortgage securities and their associated foreclosures, two people familiar with the matter said.The investigation, which began quietly in recent weeks, is part of a larger inquiry that is scrutinizing whether mortgage companies and Wall Street firms took the necessary steps under New York state law when creating mortgage-backed securities.

There was a movement by all the state attorneys general to force a global settlement on the banks to remedy the wrongs of the crisis, in particular with regard to bad documentation and unjust foreclosures. That effort has repeatedly been hit by defections and roadblocks.

From William Greider in The Nation on June 28:

As facts about the banks’ ugly behavior gathered headlines, the fifty state attorneys general came together to demand reforms. The effort was chaired by Democrat Tom Miller of Iowa and actively coached by Washington officials from the Justice Department and HUD. The Obama administration is eager to get a settlement, fearing that state-by-state litigation will injure the banks and maybe derail the foreclosure process.

The AGs first suggested a settlement of $20–25 billion—even though the true public loss would probably be much greater—plus a commitment from the banks to clean up their procedures. In exchange, the AGs would agree to release the banks from potential liabilities that states might pursue. The banks’ counteroffer was a trivial $5 billion, which suggests that they are not taking the AGs too seriously.

[New York Attorney General Eric] Schneiderman agreed to participate with other AGs, but warned from the start that New York would refuse to give up its right to hold banks liable—to sue and collect damages or impose court-ordered reforms. Other strong states, including California and Massachusetts, evidently agree. That alone would presumably doom the deal-making, since any settlement that does not include New York and California would probably not be worth much to the bankers.

In January, Bank of America settled with Fannie Mae and Freddie Mac over repurchases but there are several other suits outstanding with the Federal Home Loan Banks and private investors. Bank of America recently caved in to another group of investors. On June 29, the Financial Times FT Alphaville blog reported that a settlement had been reached between Bank of America and some bondholders.

…several news outlets (the Wall Street Journal had it first, and here’s the FT) reported last night on the expected $8.5bn settlement reached between the bank and the aggrieved parties, and earlier this morning BofA confirmed the details in a statement.

The key driver of the expected loss is the representations and warranties provision of $14.0 billion, including $8.5 billion for the settlement agreement on legacy Countrywide mortgage repurchase and servicing claims, and an additional $5.5 billion increase in the company’s representations and warranties liability for non-GSE exposures and, to a lesser extent, GSE exposures.

The company also expects to record $6.4 billion in other mortgage-related charges in the second quarter of 2011…

Audit firms PricewaterhouseCoopers and KPMG, as well as the other two members of the Big Four, are all around this crisis – in the banks, the ratings agencies, and in the regulators. And there’s a pervasive revolving door between the regulators and the banks and institutions they regulate, as well as between the regulators, the regulated, and the auditors and attorneys that serve us as watchdogs and guardians of the public interest.

But the Taylor, Bean & Whittaker convictions prove that mortgage fraudsters can be prosecuted.

The best way to get truly independent assessments of how much is wrong with the processes and the paperwork and how much compensation should be paid is for regulators to step up and take direct responsibility for the problem.

Independent individuals and firms, people who are not beholden to the large banks and financial institutions, do exist. Many next tier and regional or boutique firms have the expertise and are not in the day-to-day business of auditing or taking on large projects with these institutions.

It’s time for the regulators to build a more permanent task force of public servants rather than private profiteers to tackle these issues. The problems are really big, they’re going to get worse before they get better, and they’re going to be around for a long time.

The main page image comes from this site and this essay on the challenges to the criminal justice system, penned in 1997.

Post Script: This was a great movie about plaintiffs’ lawyers.

Post Post Script:  When I told readers in January to sell or short the banks – in particular Bank of America – the bank’s closing price was $14.667.  On Friday July 1, Bank of America closed at $11.09.

It’s a complicated case and it’s not over yet.

It’s also another case, like Satyam, that I’ve followed for a while – almost as long as I’ve been writing this blog.

Here’s an excerpt from the first article I wrote about it in October of 2007.  The case started in 2006.

With echoes of pending actions against E&Y and KPMG in Canada, PwC has now been served in the first Big 4 suit to make it to the class certification stage, according to the firm representing the plaintiffs, Kershaw, Cutter & Ratinoff…According to CFO.com, “…under California law, only certified public accountants can properly be classified as exempt from receiving overtime.”

“For years, the Big 4 accounting firms have ignored Federal and State laws mandating the payment of overtime to unlicensed accountants,” said Bill Kershaw, the KCR attorney representing the plaintiffs. “This is in stark contrast to smaller accounting firms, many of whom comply with California’s overtime law and pay overtime to their unlicensed associates as non-exempt employees.”

In June of 2008, I wrote about it again:

Take a look at this response to one of the most important points of fact in the complaint and tell me what you think is wrong with this picture..

“Answering paragraph 4 of the Complaint, PwC admits Plaintiffs are individuals and residents of the State of California. PwC further admits that Plaintiffs were employed by PwC as “associates”in PwC’s Assurance Line of Service. PwC is without knowledge or information sufficient to form a belief as to the truth of the allegations concerning Plaintiffs credentials or degrees, licensing status by a state or federal agency, test status or “Certified Public Accountant” or “CPA” designation from the State of California, and on that basis denies such allegations. PwC admits Plaintiffs bring this action as a proposed class action on behalf of themselves and certain current and former California employees of PwC. Except as so admitted, PwC denies each and every allegation ofthis paragraph in the complaint. “

Hey Jude Curtis, PwC Chief Ethics, Risk and Compliance Officer:  Shouldn’t you guys know who is licensed in each state, each and every state where your professionals work and travel, and whether a particular person has proper credentials and degrees to be an auditor?

Lawsuits are tedious. They take forever. Judges often reverse each other. It’s almost never over when you think because there’s almost always an opportunity for an appeal. Those who think an injustice has been done often only give up when they run out of money or die.

The latest twist in this case was a reversal by the Ninth Circuit Court of Appeals of a lower court decision that handed a partial summary judgement to the plaintiffs – more than 2000 PwC attest associates in California who claim they are owed overtime under California law.

Yesterday, the Ninth Circuit Court of Appeals decided that the lower court had erred in granting partial summary judgment because it misconstrued the statute. The lower court erred by finding that all of the enumerated professions, including accountants, were precluded as a matter of law from presenting evidence that their employees could meet the professional and administrative exemption requirements.

From yesterday’s decision:

PwC has viable defenses under the professional exemption and the administrative exemption. Neither exemption is categorically inapplicable to unlicensed accountants as a matter of law, and PwC has established material fact questions on whether Plaintiffs fall under either exemption. The exemption defenses must be resolved at trial.

The case is now headed to trial unless something happens before that. There’s one thing about litigation that everyone agrees on. Anything can, and sometimes does, happen.

Read the rest in Forbes.