Journalists throw in terms like tobashi to sound knowledgeable. There’s talk about the potential complicity of other parties without understanding or seeking to understand the theory and practice underlying the fraud.

How are we to prevent future frauds if we focus only on the sensational?

Japan is ripe for fraud. PwC seems to be the only Big Four auditor – well, they are not that big in Japan any more – not implicated by the fraud. PwC was hired by the Olympus ex-CEO Woodford to support his side of the story after he blew the whistle on the fraud after being fired.

PwC, who seem to be getting a lot of investigation whitewash jobs lately, was almost kicked out of Japan a few years ago for their own involvement in a major fraud. Some of the firm’s partners went to jail along with the executives.

The old Pwc Japan (Misuzu, formerly ChuoAoyama Pricewaterhouse) calls it quits. The new PwC Japan still going, although in a small way. Even they were not excited to take on any of their former colleagues accounts, for fear of the ghosts hidden behind the walls.

Misuzu operations formally halt in Japan
The 2,400 remaining employees to go to KPMG, Deloitte and Ernst & Young

“Operations of the Japanese firm, Misuzu Audit Corp, formally terminated yesterday after a 39-year-history which included several major accounting scandals involving its own employees.

Deloitte has its own scandal in Japan with Daio Paper.

And, like PwC experienced in Russia with the Yukos scandal, Olympus’ most recent and former auditors, Ernst & Young and KPMG, now have to worry about what might be found after a raid of their client’s offices by government officials.

Japanese prosecutors raided offices of Olympus Corp. (7733) inTokyo, more than a month after the camera maker admitted to a $1.7 billion accounting fraud that hid investment losses over more than a decade.

Officials from the Tokyo District Public Prosecutors Office and police entered Olympus offices in Tokyo today, the company confirmed in a statement. Footage from public broadcaster NHK showed investigators entering the building of three companies Olympus used in its scheme.

Olympus last week restated more than five years of earnings to avoid being automatically delisted from the Tokyo Stock Exchange after admitting to the 13-year cover-up.

I will keep following the story, along with Jim Ulvog, and bring you updates as they emerge.

James L. Ulvog, CPA, is a sole practitioner located in the Los Angeles area providing audits and reviews to the nonprofit community.  In 2011 he started providing peer reviews of CPA firms.  He has over 25 years experience in public accounting.

Ulvog blogs on nonprofit issues at Nonprofit Update and on issues of interest to CPAs at Attestation Update.  He also discusses the radical change taking place all around us at Outrun Change. His company website is Ulvog CPA. www.ulvogcpa.com

How Do You Hide a $1.7 Billion Loss?

Summary of the Olympus Scandal in Journal Entry Format

Olympus’ investigative committee’s report on the fraud at Olympus was released December 6. The description of the fraud, causes, and recommendations in the report are a scathing indictment of the company.

This post is a thumbnail description of the fraud based on my reading of the investigative committee’s report.  The summary report is available here.

My goal is to provide more accounting detail than shows up in the general news reports.

The report’s conclusion on page 30 compares management to a cancer:

Olympus had originally been a sound company, with diligent employees and high technical strength. Not all part (sic) of the company was involved in this misconduct. Olympus should remove its malignant tumor and literally renew itself.

Ouch. That’s gotta’ hurt.

Here are just a few of the news articles discussing the company’s report:

• The Wall Street Journal, Panel Calls Olympus ‘Rotten’ at Core. (article behind paywall),
• Bloomberg, Olympus faces Tokyo delisting after management hid $1.7 billion of losses.,
• New York Times, The Culture Was Corrupt at Olympus, Panel Finds.

What is the amount of the fraud and time frame?

According to the report, the company had incurred substantial losses on financial investments by 1990. The report indicates that through 1998 very large losses were incurred, but the investments were never written down.

The whole project got started as 2000 approached and new accounting rules would require writing down the investments from book value to market  value.

In 1998 through 2000, approximately ¥96B (~$US1.2B by my calculation) of unrealized investment losses were moved off the books. In 2003 approximately ¥118B (~$US1.5B) of unrealized losses were moved off the books. The scheme blew up this year. Losses are reported at ¥137B (~$US1.7B).

There was ¥214B/ $2.7B moved off the books according to the report, which represents the book value of the investments that were underwater.  The current loss being reported is $1.7B.  If I get the picture right, the difference between those amounts represents the market value of the investments that were moved out, plus some smaller losses incurred while the investments were held in subsidiaries.

For perspective, the March 31, 2011 audited financial statements report total assets are $US13.3B, equity is $US2.08B, net sales are $US10.59B, net income is $US92M.

The WSJ article says the losses were apparently off the books by March 31, 2010, so those amounts are after $1.7B had all been written off.

Sure seems to me that $1.7B of hidden losses is rather material.  I doubt anyone will be advancing the immateriality argument.  Compared to March 31, 2011 amounts (which is after write-off, I believe), the loss is equal to 13% of total assets, 81% of net worth, 16% of total revenue, and 18 times net income. Some amount of the loss was hidden off the books from 2010 back to at least 1998.

Also, since those losses were primarily hidden in goodwill according to the report , that loss constitutes 78% of goodwill, after the write-off.

I think several audit firms are going to be on the receiving end of some tough questions.

Arthur Andersen was the external auditor through 3-31-02. Then KPMG AZSA LLC was the auditor through 3-31-09.  The 2010 and 2011 fiscal years were audited by Ernst & Young ShinNihon LLC.

Just to complicate the picture, the report lists staff persons as assistant commissioners, which includes lots of attorneys plus 18 staff from Deloitte Tohmatsu FAS Co., Ltd. and 17 staff from Deloitte Touche Tohmatsu LLC.

On the other hand, the report also mentions the fraud was hidden quite well. Three banks were also involved by hiding information from the auditors. The summary report says all three of them agreed not to tell auditors the information that would normally be provided on an audit confirmation.

How do you hide a $1.7B loss?

Now I’d like to discuss the debits and credits.

Since reading the first reports, I’ve been wondering how you can hide investments that are underwater by $1.7B.

Here is a one paragraph summary from page 5 of the report:

The lost disposition scheme is featured in that Olympus sold the assets that incurred loss to the funds etc. set up by Olympus itself, and later provided the finance needed to settle the loss under the cover of the company acquisitions. More specifically, Olympus circulated money either by flowing money into the funds etc. by acquiring the entrepreneurial ventures owned by the funds at the substantially higher price than the real values, or by paying a substantially high fees to the third party who acted as the intermediate in the acquisition, resulting in recognition of large amount of goodwill, and subsequently amortized goodwill recognized impairment loss, which created substantial loss.

(Grammar issues are in the original, which is understandable because this is the English translation from the Japanese report.)

Here’s my understanding in one sentence:

Olympus indirectly loaned money to an off-the-books subsidiary and then sold the investments that had the huge losses to the subsidiary at historical cost, eventually paying a huge premium to buy some other small companies and writing off the underwater investments as if they were goodwill impairments.

Journal entries

I’m going to walk through what I think the summary journal entries would be. Think of the old t-account analysis you learned in school. This will be in accounting shorthand, so only accountants will likely appreciate it.

If you want the long version, the last two pages of the report have diagrams showing the flows of money. Be forewarned that there are 17 different entities on each graph with lots of arrows, so it’s a bit complicated.

So, here goes the simple version. Let’s look at the Olympus entries in highly condensed form. I’ll condense the story into 8 journal entries.

• DR Certificate of deposit that was in turn loaned to unconsol sub
• CR Cash
• Transfer cash to new, unconsolidated sub

This is a summary of a complex move – it involved making a CD deposit at several banks, who were asked to loan the money back to an apparently unrelated entity, with the CD as collateral, so the sub can buy investments from Olympus.

According to the investigative committee’s report and the New York Times article, three banks were involved through the course of the whole project:  Commerzbank, LGT, and Société Générale  The committee’s report and NYT article both indicate that all three banks  agreed to Olympus’ request to not tell the auditors  about the CDs being collateral for a loan.

• DR Cash
• CR Financial assets that are seriously underwater (probably not the actual general ledger account they used)
• Proceeds from selling underwater investments to new, unconsolidated sub

Eventually the CDs would have to be rolled over and brought back. In addition, the unrealized losses would have to be written down eventually, so the second phase was launched.

Olympus bought some tiny companies. They paid humongously more than they were worth and paid big dollars for consultants for their service as finders and intermediaries.

The effect of these transactions was to transfer money into the newest consolidated subsidiary, which used the money to buy the bad investments from the older, unconsolidated subsidiary. The unconsolidated sub then repaid the note payable to the bank and Olympus pulled back their CD.

The investment in the consolidated subsidiary shows huge goodwill, which could then be either written off over time or written down completely when it was determined to be impaired.

Here’s my understanding of the journal entries on Olympus’ books for phase 2:

• DR Investments in startup subsidiary
• DR Goodwill – tons of it, since the subs have minimal FMV that can be identified, so there must be lots of goodwill
• CR Cash
• Make several investments in new subs – note these have minor revenue and assets

• DR Cash
• CR Certificate of deposit (that had in turn been loaned to unconsol sub)
• This is for the cash coming back from the unconsol sub repaying their loan, which was used to transfer out the underwater investments

Here’s the entries on the newly formed consolidated subsidiary:

• DR Cash
• CR Common stock
• Cash investment from Olympus used to buy 3 little companies

• DR Financial assets that are seriously underwater (bought from unconsol sub)
• CR Cash
• Buy underwater investments from unconsol sub at book value

Here’s the entries on the older, unconsolidated subsidiary:

• DR Cash (from consolidated sub)
• CR Financial assets that are seriously underwater
• Proceeds from selling underwater investments to newly formed consol sub

• DR Note payable to intermediary bank
• CR Cash
• Repay loan to European and Asian banks

Therefore the net effect is the bad investments were moved into a new subsidiary, converted into goodwill, then written off as a goodwill impairment. You can guess what the press releases could then say: That investment in new technology or start-up or cutting edge idea or other-excuse-given-for-unsuccessful-subsidiary just didn’t work out and those accounting rules required the goodwill to be written off.

And thus the tanked investments would be off the books with the unrecognized loss written off as goodwill amortization or impairment.

Hiding losses was legal and normal

Apparently, moving underwater investments off the books was so common in Japan that it had a nickname, tobashi. The investigative committee’s report uses the phrase but does not explain it.  The Wall Street Journal article reports that senior leaders:

…devised a plan to transfer the bad assets off Olympus’s books to firms that weren’t officially connected with the company and so wouldn’t appear in Olympus’s accounts, the report said. The intention was to unwind those transactions gradually, allowing Olympus to take the losses secretly, over time. This type of operation had been employed by so many Japanese companies in the 1990s that it was widely known in Japanese as tobashi, meaning, to send something flying away.

KPMG did tumble to one of the tobashi schemes carried out through one of the three different routes that had been set up. I’m not sure if this is the only scheme through that particular bank or just one of several.  The WSJ article continues:

Not everything was going smoothly. The report said that in 1999, Olympus’s then-auditor, KPMG AZSA LLC, came across information that indicated the company was engaged in tobashi, which recently had become illegal in Japan. Messrs. Mori and Yamada initially denied KPMG’s assertion, but the auditor pushed them that same year to admit to the presence of one fund and unwind it, booking a loss of ¥16.8 billion. The executives assured KPMG that was the only such deal, the report said.

Looks like there was quite a nasty fight over that write-down.  Notice that tobashi was finally made illegal sometime before the 1999 audit. That means it was an acceptable approach previously.

A few thoughts here on the auditors’ actions:

How do you perform an audit for a global investor audience in a local economy where intentionally hiding losses is legal? How do you function in a business environment where that is acceptable and normative?

On the other hand, notice how one audit team, from KPMG in 1999, did find one part of the scheme.  Management lied bv denying it even existed. After agreeing to write it off, Olympus senior management lied again and said it was the only one.

On the other hand, the scheme expanded, without detection, for another 6 years or so and was in place, without detection, until the last component was unwound at the end of fiscal year 2010.

I’ve run out of hands, so back to the story.

When did the scheme finally get unwound?

The last part of the bad investments was finally written off in March 2010, according to the WSJ article. That month, by the way, would have been the last month of the fiscal year when Ernst & Young took over the audit from KPMG :

Messrs. Mori and Yamada decided to unwind and write off the whole thing, using three small Japanese companies: …. Olympus bought the trio in 2008 for the highly inflated price of ¥73.2 billion and wrote the bulk of that amount off the next year, an arrangement that allowed it to repay the loans it had borrowed from LGT and close down the European route in 2008, the report said.

Note: LGT is one of the three banks used to hide the money flow.

That left only the funds in the Singapore route still operating, the report said. Olympus internal documents said Messrs. Mori and Yamada wrote off those losses using $687 million in fees attached to Olympus’s acquisition of U.K. medical-technology firm Gyrus Group PLC as cover. The last bit of that deal was completed in March 2010. Those fees were paid to the company run by Mr. Sagawa, one of the brokers who first proposed the loss-covering operation to Olympus 12 years earlier.

Note: There were three different ‘routes’ set up to get the bad investments off the books.

When did this mess get started?

A bit more detail on the front end of this mess. The WSJ article points out the fiasco started back in about 1985 with management pushing aggressive investments that didn’t work out too well.

Exchange rates started generating losses on those investments in the late 80s. Thus the fraud was running from about 1985 through 2010, when it was all written off. The fraud blew up in October of this year.

That is why you will see comments that this fraud was running for 20 years. That is also why the WSJ article leads with:

The secret held for a quarter-century, quietly passed among senior executives.

Causes of the fraud

The report was harsh in identifying the causes, starting at page 23. Just a few causes that were mentioned:

• Collusion and intentional fraud by management
• Very poor corporate culture which punished dissent
• No document trail (this is something to remember in the long discussion of auditors’ work that we will have later)
• Poor corporate governance
• Poor follow-up by the CPA – this obviously requires lots more follow-up by the committee and others.
• Outside collaborators (this could eventually include three banks and a host of attorneys, intermediaries, finders, and consultants)

The New York Times article comments about cooperation from the outside banks who did not give full answers to the audit confirmations:

The report says that Olympus had persuaded several banks, including Société Générale of France, to submit incomplete financial statements to auditors, apparently in an effort to conceal financial maneuvers that the report says involved at least $1.7 billion and were meant to hide failed investments during the 1990s. There is no indication the banks knew of Olympus’s cover-up, the report said.

According to the report, Olympus told the banks that they did not need to respond to KPMG queries about collateral, which was used to finance loans to investment funds involved in the loss cover-up.

Keep that bit of trivia in mind as we read the soon-to-arrive avalanche of articles saying it was all the auditors’ fault.

Recommendations

The recommended changes are extensive and harsh. Here are a few of the committee’s recommendations, starting on page 27:

• Replace management who did nothing about the issues identified by the auditor in 2009 and 2010. Replace the board members who addressed those issues in a mere 15 minutes.
• Remind the current auditor, who missed things in their first audit in 2010, of “…the importance of its duties…” Ouch. Think that will be a painful meeting with the board?
• Don’t hire the president’s buddies or business partners.
• Change the attitude and mindset of management. Also, make sure management, directors, and auditors know they have a responsibility to society in carrying out their duties. Ouch. Slam in the last sentence – new members of management should have “…moral value and sense of compliance”.

Ouch again.

• Change corporate culture to one that is focused on compliance with policy, not just following orders.
• Reform many of the systems of the company. Corporate culture overhaul, HR system reform, periodic rotation of duties, and lack of whistleblower system all need to be addressed.

Like I said, a rather harsh report.

One final idea. Think about the sheer size of the fraud.

Picture a company that can absorb $1.7B of losses and keep going as if nothing happened. Then they have enough cash ($2.7B) to fund some round-about loans to buy the assets and return the cash to Olympus.  That leaves $2.7B sitting on the books as an unusable CD.

After that, they have enough cash sitting around to float $2.7B again, but this time it’s sent to the consolidated sub, which passes the money to the unconsolidated sub, on to the various banks, and then back to Olympus.

Imaging having enough spare cash after absorbing the loss, enough cooperation from enough people, and sufficient skill to discretely push $2.7B in a meandering trip through the world’s banking system, twice.

Finally, in what will generate lots of discussion, picture that the whole thing was hidden well enough that dozens of audit teams from three different audit firms over 25 years stumbled onto only one part of the fraud in only one year, and that was toward the beginning.

I think we will be talking about this a lot. I hope my comments in this post move the discussion forward.

Many thanks to Francine for the opportunity to be a guest blogger!

Main page photo is cropped image of  Daedalus Print “Mt Olympus” by Cecil Kim.

A judge’s dramatic ruling against directors and officers in the Centro “true and fair” disclosures case, has left the business community in Australia shaking in its boots.

In a landmark decision, the Federal Court has found that executives and directors of troubled property group Centro breached the Corporations Act by signing off on financial reports that failed to disclose billions of dollars of short-term debt.

The ruling in Melbourne today comes as a significant win for the Australian Securities and Investments Commission (ASIC), which poured considerable resources into the case following a string of high-profile losses.

In the United States, many wonder, now openly and loudly, why we haven’t seen more executives and boards called to account for the financial crisis. Passionate arguments – and dismissive ones – have been made on both sides. But no one argues that, compared to previous crises like post-Enron and the savings and loan scandals of the 1990’s, the number of significant prosecutions for fraud, accounting manipulation, and malpractice by third party advisors like lawyers and auditors is practically nil.

Members of company boards of directors, above all, seem bullet-proof.

The principle of fiduciary duty governs directors under state corporate law. A company can incorporate in any state, but Delaware leads the pack in the number of incorporations and, as such, as developed the most case law regarding duties of directors. Under federal law, the focus of directors’ responsibilities is on disclosure of material information  – completely and accurately.

Missing and misstated disclosures were the central issues in the Centro case.

The business community in Australia is divided over the judge’s decision. On one side, investors applaud Judge Middleton. He held the Centro directors and officers responsible for misstatements and omissions of material information. On the other side are executives and directors – many of them also investors – who claim the judge’s decision is unreasonable to expect what, they say, a director cannot reasonably be expected to do…

For the rest of the post, please go to, “PwC Will Answer For Centro But Judge Slams Directors First.”

“The reliability of global capital markets depends on auditors fulfilling their obligation to investors to perform robust audits, resulting in well-founded audit reports. Two of the PW India firms, PW Bangalore and Lovelock, repeatedly violated PCAOB rules and standards in conducting the Satyam audits. These confirmation deficiencies contributed directly to the auditors’ failure to uncover the Satyam fraud.”

James R. Doty, PCAOB Chairman

We waited eight hundred and eighteen (818) days to see Price Waterhouse India held accountable for audit failure at Satyam Computer Services, the NYSE-listed Indian IT services provider. On April 5, 2011, the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) announced settled disciplinary orders against five firms, members of the PricewaterhouseCoopers LLP (PwC) global network, for violations of PCAOB rules and standards and for violations of federal securities laws as well as improper professional conduct by PW India while PW Bangalore served as auditor of record for Satyam. In addition, the SEC also sanctioned the PW India firms for, “violation of Section 10A(a) of the Exchange Act by failing to conduct procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts.”

The PCAOB had to admit that they missed the fraud and the pervasive country-wide auditing standards violations when they inspected PW India and the Satyam engagement in February 2008.

The sanctions are significant. When the scandal hit, PwC started making changes right away to the organization, including bringing in outside talent to conduct a review of every audit involving a foreign issuer.

The monetary penalties are not significant, in spite of the fact that they are the largest ever levied against a foreign registered audit firm. In my opinion, if a combined fine of $7.5 million is a record, that only proves how lackluster prior SEC enforcement against foreign registered audit firms has been. It also shows how crippled the PCAOB has been to even inspect many foreign audit firms, let alone pursue enforcement issues in a timely and vigorous manner since its establishment under the Sarbanes-Oxley Act of 2002.

There were no SEC or PCAOB disciplinary actions against Deloitte Netherlands for the Ahold fraud, although the Dutch accounting regulators censured the firm and the partner responsible for the account.

There were no SEC or PCAOB disciplinary actions against Deloitte & Touche International, Deloitte US, Deloitte Italy, or Grant Thornton for the Parmalat fraud, even though all of them settled with the company and other shareholders. The Parmalat fraud was also perpetrated by management’s use of forged confirmations. The auditors violated standards and were accused of a profound lack of professional skepticism.

There were no SEC or PCAOB disciplinary actions against PwC for the Yukos scandal.  I started writing about Yukos in March of 2007. That’s more than four years ago! Reports have been open and consistent in saying PwC was pressured to withdraw ten years of audits as part of a Russian government prosecution of former Yukos chief Mikhail Khodorkovsky and his business partner Platon Lebedev. PwC is using the “we were duped” defense.

There were no SEC or PCAOB disciplinary actions against PwC or its Japanese firm for the Kenebo and Nikko Cordial scandals. PwC subsequently shuttered its Japanese firm and restarted under another name. I guess it was impossible to cleanse the reputation of that horribly tainted firm.

It’s the potential for sudden conflagrations in developing countries that keeps the global audit firms - PwC in this case - up at night. The legal quagmires in developed countries are messy, too.

The audit firms’ global networks are loose confederations of independent legal entities tied together only by their greed and the dependence of the less powerful member firms on the more powerful ones through the legal construct called the international coordinating firm.

If only the plaintiffs’ lawyers would get it straight and realize that the member firms are not agents of the international firm. The international firm is a sham vehicle used to impose the will of the powerful firms on the less powerful firms via the Global Board of Partners. This is the key to winning against the US, UK, and the international coordinating firms.

The loss of a major network member firm from regulatory or legal actions  - Japan, Russia, Germany, Australia, the UK, India, Ireland, and soon China – would mean the end of these networks as we know it. But will local regulatory and political forces allow it?  This is the closest we’ve come to regulators shutting down a foreign audit firm and, yet, the firm was allowed to essentially start over with generous help from the rest of the PwC global network. As serious as these sanctions are against PW India – and they will be costly – this decision essentially allows history to keep repeating itself, over and over, audit failure after audit failure.

It’s moral hazard at its highest level.

When Arthur Andersen imploded the opposite occurred. The indictment of the US Andersen firm meant all the other AA firms around the world were suddenly left out on their own. They were free to make new alliances in order to serve their local clients and to participate in the work needed to service multinationals doing business in their country.

Today, it’s not the US firms that are most seriously threatened with extinction – although there are significant threats such as to Ernst & Young with regard to Lehman. The larger threat is to one or several of the large member firms outside of the US as a result of scandals such as Satyam, Glitnir, and Yukos.

When the news of the SEC and PCAOB disciplinary orders broke on April 5, I wrote this in Forbes:

PwC believes that the US regulatory actions against PW India are over.

“These settlements, in which PW India neither admits nor denies the U.S. regulators’ findings, apply only to the U.S. regulatory enquiries into Satyam.  Neither of the orders found that PW India or any of its professionals engaged in any intentional wrongdoing or was otherwise involved in the fraud perpetrated by Satyam management. The settlements mark the end of the Satyam-related U.S. regulatory enquiries concerning PW India and are a positive step and important milestone in putting the Satyam issue behind PW India. PW India remains hopeful of resolving the outstanding enquiry with the Indian market regulator.”

PCAOB board member Jay Hansen and Director of Enforcement Claudius Modesti were interviewed on April 9 by Menaka Doshi for CNBC India’s The Firm. Doshi conducted a long and thorough interview that included several questions about future enforcement actions against responsible individuals at the leadership level, in addition to the general actions against the PW India audit firm.

Doshi wanted to know if Hansen and Modesti agreed with PwC’s statement that, “Neither of the orders found that PW India or any of its professionals engaged in any intentional wrongdoing or was otherwise involved in the fraud perpetrated by Satyam management.”

The SEC’s order says their investigation is continuing. Claudius Modesti was circumspect in responding to Doshi’s questions – in particular about hypothetical future findings of collusion on the part of PW India or its partners – but he was emphatic:

“The statement you are referring to is their statement not the Board’s… I do not view the Board’s enforcement order as absolving…I can’t comment on the rest of our investigative process because it’s confidential… If courts of law or other regulators are developing new facts or making findings we are always going to be mindful of that…The SEC has its own laws and regulations on its process…”

This case, in my opinion, is not closed.

Thank you for reading to the end.  This post is the 1000^th entry on this site.

Main page image is album cover art from UK band Arclight’s release, The Fat Lady Sings.

The Farce of Small U.S. Auditors in China By Eric Jackson

11/29/2010 2:30 PM EST

Over the last two weeks, a huge drama has been playing out with a small-cap China stock called RINO International (RINO – commentary – Trade Now). The wastewater filtration equipment provider to the Chinese steel industry was accused by Muddy Waters LLC of fraud earlier this month. RINO said nothing in response, dragged its feet and then released the following baffling 8-K last week…

I waited for the inevitable case that implicated a Big 4 audit firm. When it came – two of them at the same time – it coincided with a great new research paper from the PCAOB on the Chinese reverse merger phenomenon and the risks the model presents to auditors and their clients – investors.

Here’s an excerpt from today’s piece at Forbes. There are plenty of links to other reports about the two companies and their auditors that are now in the news for the worst possible reasons – China Agritech/Ernst & Young and China Media Express/Deloitte.

Both China Agritech and China Media Express are listed on NASDAQ because they are Chinese reverse mergers (CRM). A reverse merger is any acquisition of a private operating company by a public shell company that typically results in the owners and management of the private operating company having actual or effective voting and operating control of the combined company. Through a reverse merger transaction, although the public shell company is the surviving entity, the private operating company’s shareholders control the surviving entity or hold shares that are publicly traded. In a reverse merger transaction, the entity whose equity interests are acquired (the legal acquiree) is the acquirer for accounting purposes. Through such a transaction the private company becomes a SEC reporting company with registered securities without filing a registration statement with the US SEC.

A recent research note prepared by the US accounting regulator, the PCAOB, explains how these quickly constituted public companies meet the SEC requirement for audited financial statements.

Companies, including CRM companies, are required to file audited financial statements with the SEC, and the auditors of those financial statements are required to be registered with the PCAOB. ORA staff found that, after a reverse merger transaction, the auditor of the former shell company frequently is dismissed; the post-merger public company usually retains the Chinese operating company’s auditor, which as noted below is often a U.S. accounting firm.

As of March 31, 2010, the PCAOB says the largest number of CRM companies – 94% of the total, 97% of the total market capitalization – are audited by accounting firms that are scheduled to be inspected only every three years. These are small public accounting firms, not the biggest ones. The remaining CRM companies are audited by a firm that is inspected on an annual basis. These are typically the US or Chinese member firm of a Big 4 global network. US-based firms audited 116, or 74% of the CRM companies and Chinese registered accounting firms audited 38, or 24%.

The challenge to the PCAOB when trying to insure quality audits for CRMs is twofold:

1. Smaller US-based audit firms that are only inspected every three years may not have had their Chinese-related engagements reviewed because their relationship with the the Chinese-related client is recent.
2. The PCAOB is forbidden from inspecting Chinese-based firms, even the member firms of the Big 4 global networks. China Agritech and China Media Express were audited by Big 4 firms, but neither of these firms has been inspected yet in China by the PCAOB.

Please go to my Forbes column, Accounting Watchdog, to read the rest.

The Big 4 audit firms are preoccupied with significant legal issues in the US. KPMG has an upcoming trial for the New Century collapse. PwC is still being sued by angry AIG shareholders. Deloitte has plenty to do defending themselves against Bear Stearns and Merrill Lynch litigation. And Ernst & Young, poor EY, has Lehman.

Managing these cases requires exorbitant amounts of the US firms’ time and money. Their international umbrella firms and, in many cases, members firms in other parts of the world are also burdened. It’s my estimate that Big 4 leadership spends 75% of their time on litigation matters. An embarrassing amount of partner capital that could be used to train professionals, improve quality and stop staff and partner cuts is being spent instead on legal bills.

But let’s consider for one moment that the US firms are not the center of the universe for the global franchise. Although US revenues are significant, profits and growth are not necessarily stellar compared to the potential in other geographies.  So the firms will plow foreign fields instead and hope for revenues from IFRS conversion to save the US.

There’s quite a bit of news coming out of India, for example. The Times of India reported,  “[Dennis] Nally has decided to visit India once in every three months as part of PwC’s enhanced focus on emerging markets…while the Price Waterhouse name being dragged into India’s biggest corporate fraud did have a negative impact on the PwC brand, the controversy did not result in a large number of its clients either walking away or driving harder bargains.”

Maybe he forgot about all the PW partners and employees leaving the India firm.  In any event, we will never know since the firms do not report detailed results or headcounts by country. Rest assured, Dennis Nally is not going to India because he likes matar paneer.

In spite of their optimism about non-US geographies, KPMG, PwC and EY have plenty to worry about outside the US, too. The Madoff feeder fund lawsuits are now rolling.  Although claims are being made in the US, the majority of the action will be about member firms in Luxembourg, Canada, Dublin, the UK, Bermuda and the Cayman Islands.

EY still has to worry about Hong Kong, where a scandal seems to erupt every month.  Even though the EY international firm has refused to chip in for these claims, the loss or crippling of an important franchise has an effect on service to all multinationals in that country.

Just ask PwC about India. Or Japan. Or Russia.

Or you can ask Deloitte about Italy. Deloitte is facing its second messy situation in Milan. Maybe they should have implemented the “Grant Thornton solution” after Parmalat – cut them off. But then how would they provide service to multinationals in Italy?

The Lehman report has galvanized accounting industry critics in the UK.

Ernst & Young’s attempts to brush aside criticism of its role in the collapse of Lehman Brothers has failed to deter critics of the profession…Tory shadow chancellor George Osborne said yesterday he wants reform as much as Liberal Democrat treasury spokesman Vince Cable and Prem Sikka. Sikka has spent more than 20 years arguing that accountancy firms appear, like the Woody Allen character Zelig, in the foreground at every major corporate crash, only to fade from view when difficult questions are asked.

There are additional risks for clients when the external auditor performs work to support an audit in multiple global locations. Audit Committees should understand how and where work is performed, supervised and quality controlled when firms depend on member firms in other parts of the world.

The last out for the audit firms could come from almost anywhere.

India’s Central Bureau of Investigation (CBI) recently arrested Mahindra Satyam’s internal audit head V S Prabhakar Gupta for his alleged involvement in the Satyam fraud. Gupta, who is Global Head of Internal Audit at Mahinda Satyam, held the same position in Satyam Computer Services Limited.

“… arrest on November 21 of the company’s former global head of internal audit V S Prabhakar Gupta, who has been charged with “willful suppression of auditing irregularities.”

Ironically, in 2006 Mr. VSP Gupta and his team at Satyam,  “joined the elite list of companies across the world to have received the “Recognition of Commitment Award (ROC)” from The Institute of Internal Auditors, USA (IIA).”

IIA Communications Manager Scott McCallum responded regarding the “award”:

“Although their press release indicated that it was an “award,” in actuality, it was a “recognition” presented by The IIA after their company submitted required documentation demonstrating their “commitment” to internal audit quality… Any company was eligible to receive this same “recognition”.  Satyam was not singled out as superior… The IIA had not attested to the quality of their internal audit practices or compliance with IIA Standards through a Quality Assurance Review.”

Internal auditors have a tough job.  Some companies are very supportive of the function. But many only look at internal audit as a necessary evil and a cost center. In the end, even with a professional code of ethics and a reporting relationship directly with the Audit Committee, internal auditors are still beholden to the company, as an employee or paid vendor. They are human – subject to self-interest and, potentially, coercion in the name of keeping their job/engagement.

It’s pretty unusual for internal auditors to get caught up in scandals. They’re typically “inside” guys not flashy “outside” guys. As employees or vendors, they are often left with a Hobson’s choice: Lose their job/client by objecting or quit, tell story, and be blackballed.

Was Mr. Gupta really an active player in the scandal or just a passive enabler?  Some reports paint him as a strategic advisor who gave scammy ideas to the CEO/CFO.

“Gupta had connived with the conspirators in not raising his voice when there were indications of bungling of accounts by the management, particularly in creation of fictitious invoices. As the head of internal audit, Gupta did not resist the management when it denied access of software highlighting irregularities to an independent audit committee.”

I have been accused of naïveté regarding Indian business practices:

“…India ranks around 120 on the Transparency International’s list of most corrupt countries….almost all Indian listed companies except maybe the Tata group and HDFC companies are riddled with some degree of fraud or corruption.”

India is actually 84^th.  My reporting of the Satyam scandal is unfair how?

The Indian regulators’ latest charges confirm my earliest suspicions – that the Satyam scandal was deeper, more widespread, and required the complicity of many, both inside and outside the company. The PwC India partners are still in jail a year later awaiting trial for their crimes.

The investigative agency also claims to have collected more evidence against PricewaterhouseCoopers’ two auditors Subramani Gopalakrishnan and Talluri Srinivas, who have already been charged with ‘knowingly certifying forged and inflated balance sheets’. “Further evidence collected revealed the role of two statutory auditors in the fraud.”

The commenter went on to say it’s “the sheer hard work of the employees of [Price Waterhouse India] which has kept the firm afloat for 125 yrs…it is not uncommon for the firm to have partners who are related to each other as we live a long family tradition. Typically the partners of the firm are very conservative and many times would marry there sons and daughters in families which have a long tradition in public accounting therefore creating a more and more refined gene pool of public accountants who go on to serve the firm.”

So, Price Waterhouse auditors in India are a “super race” of the best and brightest?  Half-human and half- sly, cunning Bengali tiger?

Who knew?

But the “pressure” itself feels like a strategy orchestrated by the audit firms to force legislators to grant their wishes under the mistaken assumption they’re “regulating” the industry.

Let me break it down for you.

There’s been much more noise made by legislators and regulators in the UK regarding the auditors’ role in the financial crisis than in the US. Banks failed there, too. The government bailed them out, although it looked more like nationalization. The difference is they’re not afraid to admit it.

Mainstream media publications such as the Financial Times and the Guardian have been full of stories about the auditors and what they did, and did not do, to warn of the crisis or mitigate the impact to investors.

The UK regulators have gone through the motions, wringing their hands. The angst has even spread to the European Union, where Michel Barnier has voiced overall displeasure with the audit firms and threatened new laws and regulations.

But the firms’ master plan hit a speedbump at end of November. The leaders of the largest audit firms – Ian Powell, chairman of PwC UK, John Connolly, Senior Partner and Chief Executive of Deloitte’s UK firm and Global MD of its international firm, John Griffith-Jones, Chairman of KPMG’s Europe, Middle East and Africa region and Chairman of KPMG UK, and Scott Halliday, UK & Ireland Managing Partner for Ernst & Young – appeared before the House of Lord’s Economic Affairs Committee and let their cat out of the bag.

The auditors admitted they did not issue “going concern” warnings for any of the large banks that were eventually nationalized because they were assured during private, confidential meetings with government officials – Lord Myners in particular – that the government would bail out the banks if needed.

The admission was “astonishing” said one member of the Committee, Lord Lawson.

Accountancy Age, November 23, 2010: Debate focused on the use of “going concern” guidance, issued by auditors if they believe a company will survive the next year. Auditors said they did not change their going concern guidance because they were told the government would bail out the banks.

“Going concern [means] that a business can pay its debts as they fall due. You meant something thing quite different, you meant that the government would dip into its pockets and give the company money and then it can pay it debts and you gave an unqualified report on that basis,” Lipsey said.

Lord Lawson said there was a “threat to solvency” for UK banks which was not reflected in the auditors’ reports.

“I find that absolutely astonishing, absolutely astonishing. It seems to me that you are saying that you noticed they were on very thin ice but you were completely relaxed about it because you knew there would be support, in other words, the taxpayer would support them,” he said.

I found the admission to be quite astonishing myself. I reprinted it on my site, based here in the United States, and some in the US also found it rather astonishing.

But the revelation was never reported or explored further here in the US by any other journalists. Last week, Lord Myners refuted the auditors’ version of their meetings with him during the crisis.

Reuters London, January 18, 2011: “It was not my task to give them comfort,” Myners told the economic affairs committee of Britain’s upper house of parliament.

After that meeting the auditors gave unqualified endorsement to the accounts of UK banks as going concerns even though the government had to support the sector, sparking public anger.

Auditors surprised the parliamentary committee last November by saying they had been reassured at the meeting with Myners that there would be government help for banks in trouble.

Myners said he had only repeated statements made by the government that it was committed to taking whatever action it regarded as necessary to maintain financial stability.

He ended the meeting by stressing the need for “clear, fair and honest” annual reports for 2008 and had not “given some all embracing guarantee that, come what may, that bank shareholders” would be protected.

“I did not want them to go away thinking the weight of responsibility has gone away, we can rely on the minister,” the former UK financial services minister and top fund manager said.

It was up to a bank’s directors and the auditors whether annual reports needed qualifying comments about going concerns.

On Monday this week, the Financial Times reported that Big 4 audit firms responded to a European Commission white paper from October on possible market reform by expressing their, “willingness to work on contingency plans with regulators – albeit at national or regional member firm level, rather than for their global networks.”

Ah yes…  I think the fiction of the “global network” model was #7 on my Top Ten Things Lawyers Should Know About Auditors.

7. You know what Global Network means? It means shifting blame. The audit industry is a profitable $100 billion revenue global business, employing hundreds of thousands of people.  The “Global Network” is the legal vehicle the audit industry uses to drive liability around, in the Big 4 version of ”Catch Me If You Can.”

The Financial Times describes the PwC solution to the failure of an audit firm network member somewhere in the world that threatens to take down an entire firm, a la Arthur Andersen. Their solution: Create a clean shell firm for the good clients and team and discard bad clients, partners, and staff in a throw-away firm.

PwC has floated the idea of developing a process that would allow “untainted” staff from a stricken member firm to transfer to a new entity under fresh management, possibly under the supervision of a trustee.

This, it said, could stop problems at one member firm from bringing down a whole network, as happened with Andersen.

PwC has a lot of experience with this “good-bank/bad bank” solution. They did it in Japan after the Kenebo scandal. They’re doing it in India post-Satyam. PwC global leadership swooped in almost immediately and took control. They pruned the Indian firm of the unwashed, diseased members by design – terminations – and by default – defections. They converted the most promising consulting business – outsourcing – to a joint venture between the US, UK and Austrailia, essentially eliminating the influence of the Indian partners since they “couldn’t handle the potential of the business.”

Deloitte’s solution is to cut off the gangrenous member firm arm immediately to stop the spread of the disease. Continuing, from the Financial Times:

Similarly, KPMG envisages a “resolution regime” to license a replacement firm while Deloitte is talking of a “reboot” facility. Stuart Diack, a Deloitte associate partner who has been working on its proposal, said the goal would be to cut out compromised parts of the affected firm in order to avoid a “disorderly run to the hills” by clients and the rest of its staff.

But while such an approach could stop the audit profession shrinking from four to three dominant firms, he acknowledged that there would be complications, including the difficulty of rapidly establishing which employees were involved in any wrong-doing.

That’s a familiar scenario for Deloitte. Deloitte stood by and watched as Grant Thornton abandoned their Milan member firm as a result of the Parmalat fraud litigation. That fraud cost Deloitte hundreds of millions in settlements, including an unprecedented contribution by their international firm towards closing the books on that disaster.

Unfortunately, the Parmalat door is open again for Grant Thornton. An Appeals Court reversed a decision by New York’s Judge Kaplan. Seems Judge Kaplan may have overstepped his authority in resolving that case in New York rather than in Chicago.

KPMG knows that being under the thumb of a federally mandated monitor in the event of a near-death by litigation is the lesser of two evils. Their leadership decided quickly who was at fault in their tax shelter scandal, threw their own partners under the bus – and withheld funds for their defense – then cut a deal with the Department of Justice. They’ve survived to thrive.

Continuing, from the Financial Times:

John Griffith-Jones, joint chairman of KPMG’s main European firm, suggested that regulators might need to compel clients to stay with a stricken auditor temporarily.

He also argued that the risk to markets posed by the Big Four was less severe than banks because they did not lend to each other.

Well, the firms can take care of retaining clients – and staff – in the event one of them is stricken. They’ve done it before – made agreements amongst themselves, I’ve heard, to refrain from poaching clients or staff when the KPMG tax shelter crisis hit. More recently their idea of calming the storm when Ernst & Young was skewered in the Lehman Bankruptcy Examiner report was to agree together not to approach their clients. But those are gentlemen’s agreements. Or, rather, pinkie-swear honor amongst thieves.

Tentative at best.

And then the Financial Times reported the pièce de résistance:

Each of the Big Four said the risks run by auditors were sufficient to warrant liability caps, however.

It’s not news that the firms want liability caps.

They want them bad.

From The Times of London Online in April 2009:

Leading accountants will meet the Government this week to plead for protection as they prepare for a surge in litigation from investors trying to recover their losses from big company failures.

The Big Four — Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers (PwC) — are braced for an increase in legal action from investors and liquidators as the economic crisis continues.

The [US] SEC fears that directors and auditors could cut secret deals under which auditors are given proportionate liability in return for glossing over the company’s accounts.

Some of the cases I mentioned in the post that used this quote in April of 2009 have been settled. But, since then, there have been new ones, in particular the cases against Ernst & Young for the Lehman failure. As soon as the auditors settle one or two, more pop up like a very expensive and time consuming game of whack-a-mole they can’t win given their current strategy.

Limits on liability – liability caps – are the solution auditors want to the problem – audit failure – that they themselves create.  It’s what they want more than anything.  They’ve humbly gone along with legislators foaming at the mouth long enough to turn it around to their favor.

It’s eerily familiar to what happened after Enron. In spite of the fact that the auditors, Arthur Andersen in that case, were clearly part of the problem not the solution, the audit firms reaped the huge benefits of the fix.

Liability caps are a pretzel logic moral hazard that legislators in the UK, and probably in the US, will soon beg the audit firms to accept.

Martin Luther King Jr.: “Morality cannot be legislated, but behavior can be regulated. Judicial decrees may not change the heart, but they can restrain the heartless.”

Cindy Fornelli, the Executive Director of The Center for Audit Quality (CAQ), leads an “autonomous public policy organization dedicated to enhancing investor confidence and public trust in the global capital markets”. The CAQ is affiliated with (and funded by) the American Institute of Certified Public Accountants, the trade organization of the accounting industry. She recently congratulated the new PCAOB Board members:

“The PCAOB is an organization of great importance to auditors, investors, and all those who see the value of high quality, independent audits of public companies. It has an important and growing mandate to meet. The three new board members bring a wealth of experience and expertise to the board.

And I’m pleased to note that each has an understanding of our complex and increasingly interconnected global markets and an appreciation of the important role that public company auditors play in protecting investors…”

I’m so glad the industry that’s being regulated by the PCAOB, the public accountants and auditors of public companies, is so pleased by the choices from the SEC’s Mary Schapiro for their regulators.

I’m not so sure investors and the public should be so thrilled. Here’s what I wrote for Forbes when the appointments were announced January 7:

Those picks do not include a single investor candidate and perpetuate a white-male, insider, auditor-friendly tone that makes me quite pessimistic. I’m less than sanguine about the possibilities for improvements and reforms needed at the PCAOB or for serious disciplinary and enforcement actions against firms and individuals for auditor failure… The SEC has, therefore, chosen two attorneys whose livelihood depends on keeping auditors out of trouble and one auditor who works for a next-tier, non-global audit firm.

The newly constituted Board, with Dan Goelzer stepping back into a member role and newly selected James Doty taking the reins of leadership, has plenty on their plate. They start their jobs February 1.

Some important things have been in the works during the last year or so while two members stayed on beyond their term expiration date while the future of the PCAOB was being decided. When the Supreme Court decision reaffirmed its existence in June, wheels were finally put in motion to select new board members. Although, for the life of me can’t figure out why, given the larger than government average remuneration, there wasn’t someone  who would take a chance and take the job earlier.

The PCAOB kicked off 2011 on January 10 with this announcement:

“The Public Company Accounting Oversight Board today entered into a cooperative agreement with the Professional Oversight Board in the United Kingdom to facilitate cooperation in the oversight of auditors and public accounting firms that practice in the two regulators’ respective jurisdictions.

This agreement provides a basis for the resumption of PCAOB inspections of registered accounting firms that are located in the United Kingdom and that audit, or participate in audits, of companies whose securities trade in U.S. markets. The PCAOB previously conducted inspections in the United Kingdom with the POB from 2005 to 2008, but has been blocked from doing so since that time.”

The agreement is critically important, not the least of which is because the PCAOB must have access to Ernst & Young UK to review the firm’s involvement in the Lehman collapse. Despite my sincere doubts about whether or not the result will be the least bit efficacious, sources have assured me the PCAOB, SEC, and Department of Justice have been investigating Ernst & Young’s role in the Lehman collapse. (And, of course, we’ll always have New York…) But the PCAOB has been hampered, unlike the other two, by this constraint.

Until now.

Ernst & Young’s Jim Turley says, “Bring it on!”

London, 10 January 2011: Jim Turley, Chairman and CEO of Ernst & Young, joined his colleagues at BDO, Deloitte, Grant Thornton International, KPMG, and PwC, in releasing the following statement.

“Over the last several years, regulation of the auditing profession has evolved substantially with independent oversight of audit firms now in place in many jurisdictions around the world. Independent oversight has made an important contribution to audit quality and investor confidence in financial markets.

The global nature of corporate activity demands that audit regulators share information and cooperate across borders. Therefore, we are encouraged by today’s announcement of a cooperative agreement between the U.S. Public Company Accounting Oversight Board and the U.K. Professional Oversight Board. We are pleased it will enable audit firm inspections to move forward and hope it will be followed by similar arrangements among other regulators which we encourage and support.

Such cooperation benefits not only the regulators and registered audit firms but also investors, whose investments today increasingly cross borders.”

The six largest audit firms in the world made a joint statement about the regulators’ cooperation agreement. They are pleased. They are encouraged. They are hopeful.

Isn’t that special?

(Six theoretically competitive private partnerships, which serve 100% of the public company market in the United States in a service mandated by regulation, join together to make a statement about that regulator. Is it just me or would this kind of “cooperation” be called something other than competitive if it came from any other industry?)

It’s time for the PCAOB Board to think about how they might respond when the audit firms are not going to be so pleased as punch. There’s much for them to address. I’ll be talking about some of those recommended changes and improvements in future posts.

But, the most important role of the PCAOB is the inspections process. Let’s take a look at how well that’s going.

Take for example the case of a sensitive inspection report, one that could blow the lid on a scam with global political ramifications, that touches on accusations of fraud, organized crime involvement, government corruption, and that may impact the judgment of whether a corporate CEO goes to jail or goes free.

I’m talking about Yukos and PricewaterhouseCoopers’ Russian member firm. But I could also be talking about Satyam and PricewaterhouseCoopers’ Indian member firm.

Mikhail Khodorkovsky was sentenced to prison on December 27, 2010 in a case against him that was strongly supported by PwC the firm but where testimony by a PwC audit partner may have exonerated him. The Russian courts did not allow that testimony, PwC did not object, and even the US State Department was involved, according to Wikileaks.

From my Forbes article dated December 30^th, 2010: In 2007, PwC withdrew all audit opinions from 1994-2003 for the Russian oil company. PwC’s move in the Yukos case has been repeatedly attributed in media reports, and by US diplomats in cables released by Wikileaks, as potentially the result of coercion by the Russian government.

On January 13, 2011, the PCAOB posted twenty (20) inspection reports to its website, including four (4) expanded reports. (Pursuant to PCAOB Rule 4009(d), the PCAOB makes public additional portions  – Part 2 – of previously issued inspection reports when a firm did not address timely certain quality control issues to the satisfaction of the Board.)

One of those was the inspection of ZAO PricewaterhouseCoopers Audit, the PwC audit firm headquartered in Moscow.  The final report is dated October 29, 2010. The inspection was completed during a twelve (12) day period in June of 2009 for audits of subsidiaries of US issuers in 2008. In the past the PCAOB issued the reports of their inspections very close to the date of the final report.  (The date of ZAO PricewaterhouseCoopers Audit’s response to their draft report is October 4, 2010.)

So why did it take so long, until January 13, 2011, to make this report public?

On its face, the report looks fairly benign. The cover tells us ZAO PricewaterhouseCoopers does not audit any Russian-based US issuers, only 34 issuers where,  “audit work [was] performed by the Firm in engagements for which the Firm was not the principal auditor, including audits, if any, in which the Firm plays a substantial role as defined in PCAOB Rule 1001(p)(ii).”

The PCAOB, however, does not make a determination if the number of direct issuers self-reported by the Russians – zero – is correct. “The number of issuer audit clients shown here is based on the Firm’s self-reporting and the inspection team’s review of certain information for inspection planning purposes. It does not reflect any Board determination concerning which, or how many, of the Firm’s audit clients are “issuers” as defined in the Act.”

So, what happened between October 4 - when the firm responded to the draft inspection report – and January 13, 2011?  I suspect the SEC told the PCAOB to hold the report until the Khodorkovsky verdict was final and any media focus on PwC’s potential role in the case was off the front page. Someone made sure the PCAOB didn’t add to the tension until the Russian courts handed down the verdict. A negative inspection report on the PwC Russian firm, issued while the media was still focused on PwC’s role in the Yukos audit, may have been disruptive.

SEC’s Rule 140, adopted quietly with no comment or press release last fall after the PCAOB Supreme Court decision, now builds in an additional delay in publishing potentially controversial reports. Although the SEC rule makes their process nonpublic, and the PCAOB can’t discuss whether any particular firm appealed to the SEC over its report, there’s a delay to allow time for a firm to seek SEC redress, which delays the report issuance process even if the firm doesn’t seek it.

(The SEC also recently gave its chief accountant, Jim Kroeker a former Deloitte partner, authority to reject PCAOB regulator proposals. Release No. 34-63699 joins a series of rules the SEC has issued in recent months, with no request for comment or fanfare, dealing with its oversight of the PCAOB. Release No. 34-63699, Delegation of Authority to the Chief Accountant, was announced on January 12, 2011. As a result, a PCAOB proposal can be rejected or temporarily suspended, provided the chief accountant gives the commissioners five days notice.)

What did we end up with, after waiting for a conclusion to a process that took more than two years after the audits were performed?

The inspection procedures included a review of aspects of the Firm’s audit work on four issuer audit engagements (out of 34 possible) in which it played a role but was not the principal auditor… The inspection team identified what it considered to be audit deficiencies. The deficiencies included deficiencies of such significance that it appeared to the inspection team that, in two of the audits performed by the Firm in which the Firm played a role but was not the principal auditor, the Firm did not obtain sufficient competent evidential matter to fulfill the objectives of its role in the audits.

That’s it. The response to the draft report from ZAO PricewaterhouseCoopers was typically fluffy and bland. The amount of time that’s passed since the audits, almost three years, allowed PwC to pull out the tried and true, “That was in the past, everything is fine now,” retort.

Which brings me back to the PCAOB inspection report of Indian firms from March 2008? Will there ever be a regulatory reaction to the Satyam fraud and the role of PricewaterhouseCoopers’ Indian member firm in the fraud?

From the Financial Times: US audit regulators raised concerns with Price Waterhouse, an affiliate of PwC, about its audit of Satyam after they visited the firm last spring, it emerged yesterday. The visit was one of a series conducted by officials from the Public Company Accounting Oversight Board to Indian auditors with clients registered in the US, including Satyam.

The regulator said: “The PCAOB has conducted inspection work in India. We do not disclose, however, the names of issuers reviewed in the course of our inspections.” PwC Global declined to comment.

January 7, 2011 was the second anniversary of erstwhile Satyam CEO Ramalinga Raju’s confession to the $1 billion plus Satyam fraud. Price Waterhouse India and PwC’s global firm have been feeling the pain ever since. They’re being sued in New York by shareholders. The new company, Mahindra Satyam, announced in October, when its restated financial statements were finally published, that the SEC had issued a Wells Notice to the company back in 2009, threatening civil action.

The Satyam executives and PwC partners involved in the audit of the firm are on trial now in India, in a slow moving Bollywood-style tragicomic soap opera that, to the outside observer, defies logic at times. We’ve heard nothing from the SEC or PCAOB with regard to disciplinary actions against the firm or the two Price Waterhouse partners who are accused of being complicit in the fraud and were in jail for almost a year.

It’s been almost three years since the PCAOB inspected Indian registered audit firms. The audits the inspectors looked at were even older than that. How much longer do we have to wait for this report? Will it bear any resemblance to the scope and findings for the work that was actually done?

How much of the delay is based on politics and the desire of the SEC to avoid “disrupting” PwC?

Leaders of the four largest global accounting firms – Ian Powell, chairman of PwC UK, John Connolly, Senior Partner and Chief Executive of Deloitte’s UK firm and Global MD of its international firm, John Griffith-Jones, Chairman of KPMG’s Europe, Middle East and Africa region and Chairman of KPMG UK, and Scott Halliday, UK & Ireland Managing Partner for Ernst & Young – appeared before the UK’s House of Lords Economic Affairs Committee yesterday to discuss competition and their role in the financial crisis.

The discussion moved past the topic of competition when the same old recommendations were raised and the same old excuses for the status quo were given.

Reuters, November 23, 2010: The House of Lords committee was taking evidence on concentration in the auditing market and the role of auditors.

Nearly all the world’s blue chip companies are audited by the Big Four, creating concerns among policymakers of growing systemic risks, particularly if one of them fails.

“I don’t see that is on the horizon at all,” Connolly said.

The European Union’s executive European Commission has also opened a public consultation into ways to boost competition in the sector, such as by having smaller firms working jointly with one of the Big Four so there is a “substitute on the bench.”

“Having a single auditor results in the best communication with the board and with management and results in the highest quality audit,” said Scott Halliday, an E&Y managing partner.

The Lord’s Committee was more interested in questioning the auditors about the issue of “going concern” opinions and, in particular, why there were none for the banks that failed, were bailed out, or were nationalized.

The answer the Lord’s received was, in one word, “Astonishing!”

Accountancy Age, November 23, 2010: Debate focused on the use of “going concern” guidance, issued by auditors if they believe a company will survive the next year. Auditors said they did not change their going concern guidance because they were told the government would bail out the banks.

“Going concern [means] that a business can pay its debts as they fall due. You meant something thing quite different, you meant that the government would dip into its pockets and give the company money and then it can pay it debts and you gave an unqualified report on that basis,” Lipsey said.

Lord Lawson said there was a “threat to solvency” for UK banks which was not reflected in the auditors’ reports.

“I find that absolutely astonishing, absolutely astonishing. It seems to me that you are saying that you noticed they were on very thin ice but you were completely relaxed about it because you knew there would be support, in other words, the taxpayer would support them,” he said.

The leadership of the Big 4 audit firms in the UK has admitted that they did not issue “going concern” opinions because they were told by government officials, confidentially, that the banks would be bailed out.

The Herald of Scotland, November 24, 2010: John Connolly, chief executive of Deloitte auditor to Royal Bank of Scotland, said the UK’s big four accountancy firms initiated “detailed discussions” with then City minister Lord Paul Myners in late 2008 soon after the collapse of Lehman Brothers prompted money markets to gum up.

Ian Powell, chairman of PricewaterhouseCoopers, said there had been talks the previous year.

Debate centred on whether the banks’ accounts could be signed off as “going concerns”. All banks got a clean bill of health even though they ended up needing vast amounts of taxpayer support.

Mr. Connolly said: “In the circumstances we were in, it was recognised that the banks would only be ‘going concerns’ if there was support forthcoming.”

“The consequences of reaching the conclusion that a bank was actually going to go belly up were huge.”  John Connolly, Deloitte

He said that the firms held meetings in December 2008 and January 2009 with Lord Myners, a former director of NatWest who was appointed Financial Services Secretary to the Treasury in October 2008.

I’ve asked the question many times why there were no “going concern” opinions for the banks and other institutions that were bailed out, failed or essentially nationalized here in the US.  I’ve never received a good answer until now.  In fact, I had the impression the auditors were not there.  There has been no mention of their presence or their role in any accounts of the crisis.  There has been no similar admission that meetings in took place between the auditors and the Federal Reserve or the Treasury leading to Lehman’s failure and afterwards. No one has asked them.

How could I been so naive?

If it happened in the UK, why not in the US?

Does Andrew Ross Sorkin have any notes about this that didn’t make it to his book?

Will Ted Kaufman call the auditors to account now that he is Chairman of the Congressional Oversight Panel?

Is there still time to call the four US leaders to testify in front of the Financial Crisis Inquiry Commission?

What is the recourse for shareholders and other stakeholders who lost everything if the government was the one who prevented them from hearing any warning?

Certainly the auditors are now more inside the room than outside.  I never take them for toadies, just standing in the corner waiting for their orders after the big boys talk, even though others have said I give them too much credit for being strategic.  Their complacence is calculated. They are much too tied into the work, and the millions in fees, that have been generated by the aftermath of the crisis. Are the millions in fees for supporting the Treasury and the Fed’s cleanup of the crisis their reward for going along? Is this the same acquiescence that doesn’t seem to bother their UK colleagues one bit?

Reuters: John Griffith-Jones, chairman of KPMG in Europe, said the banking industry is built on confidence and that full disclosure is absolutely fine in a stable environment.

“Come a crisis, the government of the day and Bank of England of the day may prefer the public not to know… to control events in those circumstances,” Griffith-Jones said.

And so the government has controlled information about the auditors’ role in the US.

No one knows whether similar meetings were held between audit leadership and the Federal Reserve Bank and US Treasury.   No one has asked them to testify before a Congressional Committee. When their presence in meetings at Goldman Sachs and AIG, for example, was exposed via emails and correspondence subpoenaed by Congressional investigators, the names were redacted at their request.

Contracts with the Treasury and the New York Federal Reserve Bank are similarly redacted.  We can’t trace whether the audit firm professionals working for the government now are the same ones working for their clients who failed.  We can’t check that those who looked the other way when balance sheets were manipulated and assets valued unrealistically are the same ones now advising how to optimize the value of those same assets for the taxpayer.  We are unable to verify if the same partners who failed us at the banks, at AIG, at Lehman, and at Bear Stearns are now managing their assets for the taxpayer.

You can listen to the Big 4 testimony before the House of Lords here.  There is much more to it and I will report on the rest at a later date. A full transcript will be available here by early next week.

Photo left to right: Scott Halliday (EY), Ian Powell (PwC), John Griffith-Jones (KPMG), John Connolly (Deloitte)

A movement to challenge the dominance of the big four auditors is gaining momentum with confirmation from regulators that many in the City back action to tackle the risks it has created…

You may think this quote is a recent one. It’s not.  It’s from more than four years ago.

Challenge to big four auditors grows

By Barney Jopson, Financial Correspondent, Financial Times, September 11 2006 03:00. A movement to challenge the dominance of the big four auditors is gaining momentum with confirmation from regulators that many in the City back action to tackle the risks it has created.

The Financial Reporting Council, the accounting watchdog, indicated that investors and companies, along with a significant number of accountants, had told it that the stranglehold of PwC, Deloitte, KPMG and Ernst & Young was unhealthy. Paul George, the FRC director responsible for its work on the big four, said: “There is enough consensus that there are risks associated with the current market structure and that there are things that can be done.”

In the past 12 months concern has intensified in the UK and beyond about the pernicious impact of the big four’s dominance on choice and quality in the audit market and on financial stability. The big four audit all but one of the companies in the FTSE 100 and 97 per cent of the FTSE 250. Their dominance is replicated in each of the Group of Seven leading industrialised economies…

Contrast that to the “outrage” expressed by UK and EU regulators and politicians during the past few months over the “dominance of the Big 4.”

“Latest inquiry”

“Mounting scrutiny”

“Dominance”

“Lack of competition”

“Threatening quality”

“Gaining momentum”

“Systemic risk”

Blah. Blah. Blah.

Yadda. Yadda. Yadda.

Same words.  Only the reporters have changed.  Probably so they don’t bore themselves to tears.  FT is now on their fourth accountancy reporter, Adam Jones, in as many years.  But at least they have a semi-dedicated one on the beat, unlike other major media. Stephen Castle is the NYT EU correspondent in Brussels. He doesn’t have an accounting industry focus. This is his first story on the auditors this year.

E.U. Concerned by Big Four’s Dominance in Auditing, By Stephen Castle, October 13, 2010 BRUSSELS — The dominance of the four big global accounting firms faced a challenge Wednesday from the European Union, which said it would examine whether laws were needed to reduce their control of the market. Announcing an effort to tighten regulation after the financial crisis,Michel Barnier, the European commissioner for financial services, said that for the auditing sector, “the status quo is not an option.”

Mr. Barnier said that the big four — Deloitte, PricewaterhouseCoopers, KPMG and Ernst & Young — controlled 70 percent of the European auditing market, while in Britain, 99 percent of the FTSE 100 companies used them.

“We think that this sort of concentration can lead to systemic risk,” Mr. Barnier said, adding that the consequences if an audit firm went into bankruptcy could be severe.

He also pointed out that auditors, along with the rest of the financial community, had failed to foresee the onset of the financial crisis. “We need more competition. We need more diversity,” he said, suggesting that smaller accounting firms should be encouraged to expand.

Forgive me for being a bit cynical, but does the UK and EU also pop in new politicians every four years as we do here in the United States such that we get a fresh crop of potato heads every term, fresh from the field, with nary a clue about the history, legacy, machinations and pervasive influence of the largest global accounting firms? Do they think no one is watching and listening?  Have they any idea of the power of Google Search or the collective memory of everyone now chronicling their repeated hollow promises of reform?

The politicians trot out the same old ideas and suggestions for audit industry reform, over and over again. They wither on the vine, abandoned when something else captures the public’s attention and after the firms have performed their public relations and political contribution magic. Is there any other industry on the planet that toots their own distracting horn as much and as often about their charitable giving and “service” days as the Big 4 audit firms – Deloitte, Ernst & Young, KPMG and pwc – in every small town, medium size city, and major municipality where they have an office?

There have been numerous studies and periodic outrage voiced in the US, before and after the Enron scandal.  The current decibel level is not as high in the US as in the UK and EU.  The “outrage” over Ernst & Young’s role in the Lehman bankruptcy lasted about a month here.  Hell, we still haven’t seen any Congressional inquisitors call Ernst & Young to testify at a public hearing about Lehman or any other audit firm to testify about all the other failures, bailouts and forced acquisitions.

The Financial Crisis Inquiry Commission finally posted some documents from PwC with regard to the AIG failure.  The PwC partners’ names were redacted even though those same partners had been named as important actors in the resolution of charges against AIG’s Joseph Cassano.

My feelings about PwC and EY receiving long-term contracts to support the “internal controls” over the TARP program are well known.  Outrageous.  Two years later, the Congressional Oversight Committee has released their report, “Examining Treasury’s Use of Financial Crisis Contracting Authority.” Amongst other findings regarding conflicts of interest and lack of transparency or accountability in monitoring these contracts, I found that the names and rates of all parties involved in the accounting-related engagements, from partners in charge to on-the-ground managers to low-level staff, are still redacted from all published copies of the contracts.

If you didn’t think politics plays a large role on the ongoing “dominance” of the Big 4 and their free pass from serious accountability for their roles in failures, you only have to look at the new IASB appointment. A “statesman” rather than an accountant has been selected and the Chairman of the US SEC applauds this.

And then there’s the conflict of interest in appearance as well as fact for the new FASB Chairman Russell Golden.  I’ll let retired accounting professor and respected SEC reporting expert Tom Selling tell the story:

First, “insider” doesn’t fully describe the culture from whence Golden comes. As with far too many FASB staff members, Golden came to the FASB straight from the Big Four, where he was a technical partner who presumably lobbied the Board and its surrogates for the accounting rules his firm, Deloitte, proposed….

Second, Golden has a track record of catering to the Accounting Establishment. Notwithstanding, CFO.com reports that “Golden says he considers his point of view to be less that of an auditor and more of someone with an ‘open mind’ about improving financial reporting, which includes balancing investor concerns with the cost of improvements to prepares and auditors.” – but, I simply don’t see any evidence of that in Golden’s past actions…

Third, and this is the whopper, one Tracey C. Golden is a highly-placed partner at Deloitte. I had heard that Russell Golden’s wife works for the Big Four, and I guess this is she. The conflict of interest for Mr. Golden must be obvious, but since the Financial Accounting Foundation seems to have not given it much consideration, I’m compelled to spell it out:

• If (as The Economist reports) Deloitte wants the FASB to converge with the IASB on loan and debt accounting, it is highly probable that this is also what Mrs. Golden wants;
• If Deloitte wants to augment its book of business by assisting US companies in a mandated conversion from US GAAP to IFRS, then it is highly probable that Mrs. Golden wants IFRS and GAAP to converge wherever possible;
• If Deloitte gets what it wants out of the FASB, then Mrs. Golden stands to become significantly wealthier, and so does Mr. Golden.

It may be no small thing for the Technical Director of the FASB, who has no formal vote, to be in a position to gain from the outcome of an FASB vote; because one might take comfort in the belief that voting members of the FASB will mitigate both the fact and appearance of a conflict of interest on the part of its Technical Director. It’s quite another thing, however, when the fate of the most consequential exposure draft in the history of the FASB has a nontrivial probability of being decided by the single vote of Tracey Golden’s husband.

I think Mr. Selling also agrees with me – and I suppose with the politicians and regulators who take up the issue every once and a while to score populist points – that the current audit model is irreparably broken. He recently repeated his key claims on a popular forum for accounting professors.  His remarks are reprinted by permission:

• Auditors lack sufficient incentives to be objective (independence is a myth, and I don’t expect auditors to be independent).
• Even if they were objective, audit reliability is questionable in two main areas:

1. Auditors are not valuation experts.  When valuations are called for, I believe that they should be made by third parties, and not management.  Auditor involvement should be limited to providing assurance that the third parties seemed to behave in an objective manner, and performed the procedures they said they would perform.

2. Verifying that highly subjective judgments made by self-interested management are “reasonable” – e.g., “probable” contingent liabilities, useful lives, salvage values, inventory writedowns, adjustments to the carrying amounts of receivables/loans, hedge effectiveness, functional currency determination, to name a few.

Most reasonable and intelligent people agree on these points. Most are also very concerned about the risk to the system if another large firm fails as a result of catastrophic litigation.  Many also acknowledge the serious threat to the quality and integrity of financial statements due to conflicts of interest and lack of  independence and objectivity inherent in the current for-profit audit firm business model.

The audit firms are no dummies. They have seen the potential for a backlash coming since the beginning of the financial crisis.  They knew it was just a matter of time until some populist politician took up the charge and they’d have to start defending themselves.  Time to turn on the smoke and mirrors machine and send out the proxies to counter the reforms they dislike with alternatives they probably won’t ever see.

It started in the UK back in early 2009. The auditors had been claiming a “good crisis.”

They fear that a blockbuster lawsuit, if successful, could put one or more of them out of business. That could trigger the collapse of the audit market and cause chaos for business, they say. All but two members of the FTSE 100 are audited by the Big Four…Last month, the US Securities and Exchange Commission (SEC), the American financial regulator, said that it would block any such deals involving British companies that were also registered in the United States.

The SEC fears that directors and auditors could cut secret deals under which auditors are given proportionate liability in return for glossing over the company’s accounts.

I wonder if the SEC still holds this position?

In another example of roadblocks to private rights of action in fraud and accounting malpractice cases, an ancient former SEC Chairman recently joined others who have played “Charley McCarthy” to the audit industry’s “Edgar Bergen.”

Former Chairman [Rod] Hills also urged the SEC to create a safe harbor for an auditor’s professional judgment. He emphasized that a plaintiff should not have the right to question an auditor’s professional judgment if the SEC and the PCAOB are happy with that judgment.

The last time I heard this one – that auditors should not be held accountable to investors for their “judgment” – it was positioned as a necessity in the event the US adopted IFRS.

Made me nauseous.

In the UK, the Big 4 have even convinced the “next tier” firms to beg for limitations on liability for the Big 4.  GT and BDO must have given up on ever bulking up enough to compete with the Big 4. Maybe they’re jockeying for a buyout.  Will we see more consolidation  - allowing Big 4 firms to buy BDO and GT, for example – rationalized by regulators as a way to insulate the industry from catastrophic claims?

Unfortunately, in the US, all of these concerns are addressed via the “too few to fail” policy – no large firm will be indicted by the federal government for criminal offenses, but civil penalties and sanctions will be meted out to culpable individuals only and only after many years of investigation when the story and the deterrent effect have been significantly diluted. Civil penalties against audit firms as a whole will be severely rationed.  The private right of action against audit firms will be constrained by the PSLRA, the Stoneridge decision, obdurate judges, and archaic legal doctrines that perpetuate the “we can be duped because we are simply humble bean counters and bookkeepers” defense. Settling cases rather than going to trial means juries and the general public will never see “how the sausage is made.”

It’s shameful.