Ooooh scary!

This has been going on now for two years and seems to have escalated into the kind of fight men have when trying to prove who’s bigger and tougher. It looks to me like it’s personal rather than productive. The SEC has access to as much as they need to review the work of the Deloitte China firm’s audit of Longtop  - or any other Chinese fraud for a US listed company - assuming the US Deloitte firm had as much as they needed to sign off on the companies’ filings with the SEC over the years.

The SEC admits in their latest complaint against Deloitte Shanghai that they asked Deloitte US for the information the firm has right here in the US on Longtop and other US listed foreign based audits. The firm’s first answer was to deny any involvement in the audit.

4. On April 9, 2010, staff served Deloitte LLP, the U.S. member firm of the Global Firm with a subpoena requesting audit work papers relating to the Global Firm’s audit of Client A’s financial statements for the period January 1, 2008 through April 9, 2010.

5. Between April 13, 2010 and May 18, 2010, staff had several communications with U.S. based counsels for both Deloitte LLP and the Global Firm.

6. Counsel for Deloitte LLP initially informed the staff that Deloitte LLP did not perform any audit work for Client A, that all audit work was conducted by Respondent, and that Deloitte LLP did not have possession, custody, or control of the documents called for by the subpoena.

7. Counsel for Deloitte LLP subsequently informed the staff that Deloitte LLP performed some review work of Client A’s periodic reports and produced certain documents relating to this review to the staff.

Deloitte did eventually produce some documents related to the audit that are, and always have been, available in the US. If the Deloitte US reviews were sufficient, that should be enough for the SEC to see the quality of work performed by the Deloitte Shanghai unit.

So why is SEC continuing to fight this inane fight when, in reality, they should have all the information they need to investigate the Longtop or any other fraud? I suspect that the SEC attorneys are super annoyed with Deloitte’s lawyers and have decided to use their unlimited budget and intimidating administrative powers to annoy them back. Unfortunately, this just puts more money in the pocket of the super expensive Sidley & Austin outside counsel representing Deloitte Shanghai.

(Coincidentally, it was also a Sidley & Austin lawyer for KPMG that recently so annoyed a judge in a class action overtime case against the firm the judge ordered the firm to preserve the hardrives of all laptops for past, present and future class members. Note to Sidley & Austin:  Scorched earth tactics not working.)

US-based GAAP and SEC reporting experts in the global audit firms review the workpapers behind the filings for every non-US based audit client that is listed on a US stock exchange, all over the world, before any filing with the SEC. That’s one of the quality control procedures all the firms who audit foreign-based, US listed multinationals have in place, not only because it is expected by regulators but because it’s good business.

The SEC/GAAP reporting team or Reg S-X review team – it may be drawn from and called something different in each firm – is the last stop before a foreign-based US issuer can file its quarterly and annual reports, as well as any filings for additional stock or debt offerings, with the SEC. Sometimes the team consists of experts from the firm’s financial advisory consulting group or capital markets group – the professionals who help companies prepare for IPOs, especially foreign companies who want a stock exchange listing in the US. The team may also call on additional expertise from the firm’s national office – a kind of one-stop shop for getting questions answered on arcane technical matters or standards for specific industries. Professionals may play double duty as consultants to some companies and remote members of an audit team for others. That way they can pick up billable hours reviewing filings when there are no deals to be done.

When a US-based listed company is a multinational, the US audit firm will use its member firm network extensively to do the audit work necessary all over the world to support the overall audit opinion. In this case, a US audit firm is expected to closely supervise and control the work of foreign affiliates who contribute to its audit.

From Part 2 of the PCAOB’s inspection report – the private quality control review of US firms.

Review of Processes Related to the Firm’s Use of Audit Work that the Firm’s Foreign Affiliates Perform on the Foreign Operations of the Firm’s U.S. Issuer Audit Clients

The inspection team performed procedures in this area with respect to the processes the Firm uses to ensure that the audit work that its foreign affiliates perform on the foreign operations of U.S. issuers is effective and in accordance with applicable standards performed by the Firm’s foreign affiliates on the foreign operations of U.S. issuer clients.

Some non-US audit member firms have more SEC reporting and GAAP experts on-site than others. I suspect the largest firms in Canada and the UK have their own SEC and GAAP reporting quality assurance review team for this purpose, but many countries do not.

PwC, for example, has the Global Capital Markets Group, a team of professionals dedicated to providing technical, strategic and project management advisory services to non-US companies actively interested in raising capital and/or listing their securities in the US securities markets. GCMG has partners and hundreds of professionals in more than 20 countries around the world.

GCMG assists companies in meeting ongoing SEC reporting requirements (e.g., review the company’s annual filing on Form 20-F and assist the company in responding to any SEC review comments). They are qualified to review management’s evaluation of the accounting treatment under U.S. GAAP and/or IFRS of new, complex or unusual transactions, such as a new type of financial instrument or a business combination. (Henri Steenkamp, a native of South Africa and a PwC alumni, is one of these accounting technical experts who helped companies prepare for IPOs for PwC before he helped Man Financial spin off MF Global and went on to become CFO of that PwC audit client.)

Take India, for example. According to the First Amended Complaint for the class action lawsuit brought by Satyam shareholders against Price Waterhouse India, PricewaterhouseCoopers US and PwC international as well as various executives and directors of Satyam, Price Waterhouse India created a multi-country, multi-disciplinary audit team for Satyam that included professionals with expert knowledge of US GAAP and SEC reporting requirements. Doing so satisfied PCAOB audit standards – which applied to Satyam because its shares (actually ADSs) were listed on the New York Stock Exchange. PW India had to assure the PCAOB, the SEC and investors worldwide that Satyam’s filings on Forms 20-F and 6-K, for example, were fully audited and reviewed in accordance with US auditing standards and were prepared using US GAAP.

The professionals PwC US brought to the global Satyam audit “client service” team are people like Suresh Persaud. Persaud was “the designated reviewer [] with respect to Satyam,” according to emails to PW India partner Gopalakrishnan and Peter Ferraro of the PwC Global Capital Markets Group that were described in the class action Complaint. Persuad was based in PwC US’s Florham Park, New Jersey office and a director in SEC-FPI (i.e., Foreign Private Issuer) Services in US National Risk & Quality with PwC US. The SEC-FPI is based in the United States. That group provides technical support to PwC GCMG on complex or unusual issues regarding US GAAP, US SEC reporting and other related matters.

PwC US GCMG provided both consulting work to Satyam and support for the audit. GCMG was paid by PW India by invoicing the Indian firm for their services. The Indian firm, in turn, billed Satyam for these hours both as part of the audit and as additional consulting services. GCMG’s review and “sign off” on PW India’s audit was required per PwC Global policy before it could be considered final. However, the PW India partners had the last word on the Satyam audit. PW India “owned” Satyam as a client. In the case of Satyam, it seems the PW India partners either got bad advice, no advice, or ignored the advice of the US quality babysitters.

For example, the Complaint describes an exchange between Melissa Bledsoe, a manager at PwC GCMG and the India team where she explains the importance of PwC GCMG’s review of Satyam filings and gives them a timeline for the review:

“We will need to have a minimum of FIVE full days to review the Form 20-F. When we receive critical matters, we expect all significant current year issues to [be] well documented and the conclusions appropriately researched and concluded.”

The Designated Reviewer Program for Satyam included 22 procedures to be completed by the reviewer prior to the submission of any filings with the SEC. The procedures focused primarily on ensuring that the Satyam audits were performed in accordance with PCAOB audit requirements. In the “Scope of Designated Reviewer Support” section, the program specifies:

“It was agreed with the engagement partner that a review of the document is required by GCMG international office as done in the previous years.”

The Designated Reviewer Program also set forth the procedure for resolving conflicts between the designated reviewer and the engagement partner.

All the forms used to complete routine audit procedures for Satyam come from PwC US according to the Complaint. The forms used in the Satyam audits included:

• MyClient US GAAS Supplement
• MyClient US Master Data Program
• PwC Audit US 3110-3180
• PwC US Template Manager
• PwC Audit Guide – US via the PwC Audit – US Lotus Notes database
• US template manager for the SUD (Summary of Unadjusted Differences)

PW India had to consult PwC US on critical issues including significant accounting, auditing and financial reporting matters and all reviews of unaudited interim information were performed as required under PwC US audit policy.

The first Amended Consolidated Class Action Complaint goes on to say that PwC US regularly reviewed and approved US GAAP accounting issues on behalf of Satyam, including for:

• Each of Satyam’s financial statements filed on Form 20-F with the SEC during the Class Period
• Acquisition of Citisoft (e.g., discussed in a July 14, 2005 email, among others)
• Sale of a subsidiary, SIFY (e.g., discussed in a January 24, 2005 email, among 
others)
• Put option and reversal (e.g., discussed in a February 9, 2005 email, among others)
• Preference shares (e.g., discussed in a December 31, 2004 email, among others)
• Variable interest entities (e.g., discussed in a July 14, 2005 email, among others)
• Summary of unadjusted differences (e.g., discussed in an April 19, 2006 email, among others)
• Goodwill impairment (e.g., discussed in a December 31, 2004 email, among others), and
• Potential restatements (e.g., discussed in August 14, 2004, March 28, 2005 and May 2, 2008 emails, among others)

“Final clearance” by PwC GCMG was a necessary prerequisite for Satyam’s SEC filings. For example, in an April 22, 2005 email to Peter Ferraro of PwC GCMG, Khazat Kotwal requested expedited turnaround of an amended F-3:

“Satyam want’s [sic] PwC’s final clearance to file the F-3 on APRIL 25, 2005. Kindly call me immediately if you have any concerns to meet this deadline. I do not want to be in an embarassing [sic] position once more in front of the client. Also, note that there is a lot at stake for the client so even if we all have to stretch ourselves we should do that. Looking forward to a positive response from you.”

PwC GCMG acceded to the artificial deadline imposed by Satyam, according to the Complaint, and allowed the amended F-3 to be filed shortly thereafter with little further review.

In spite of so much involvement of the US firm in the Satyam audit, including critical quality reviews as safeguards for US investors before reports were filed with the SEC, the SEC and the PCAOB sanctioned and fined only the Pricewaterhouse India firm for the negligent audit that missed a $1 billion fraud.

The Public Company Auditing Oversight Board (PCAOB) has not been prohibited from inspecting Indian firms like they have been in China and the EU. The PCAOB inspected the PW India audit firm for the first time in the spring of 2008. We did not see a copy of that inspection report until three years later, in April of 2011, when the SEC and PCAOB jointly issued sanctions and a $7.5 million fine against the PW India firm.

It revealed a type-two error:

“Following the performance of the inspection procedures, a significant issue came to light that had not been identified in the inspection review.”

And that’s pretty much all the public section of the PCAOB inspection report says. It does describe, briefly, the subsequent events that forced the regulator to throw out any conclusions they had come to during the inspection.

The class action settlement, a private civil matter in New York federal courts, did however hold the US and the International PricewaterhouseCoopers firms liable for the Satyam fraud in addition to the India firm. PW India, PricewaterhouseCoopers US and PricewaterhouseCoopers International Ltd settled with investors for a total of $25.5 million. It’s not clear how much each contributed but there have been recent reports out of India that the local firm received funds from the International firm which could not be traced to payment for services. It’s against the law in India for a local audit firm to be subsidized by a foreign one.

By over and over again singling out only a single country practice for sanctions and disciplinary action, the SEC and PCAOB imply that the work of an audit of a US-listed, foreign, multinational company is performed in isolation.

It is not.

From the First Amended Complaint:

Notably, Satyam’s audited and unaudited financial statements prepared under Indian GAAP for the quarter and half year ended September 30, 2004, filed as exhibits to the October 25, 2004 6-K, were signed on behalf of the Board of Directors and by Price Waterhouse, by Gopalakrishnan, in “Santa Clara [California], USA.” Santa Clara, California is a location of Satyam’s US operations.

PwC International has also paid for the legal counsel to both PW India partners, Gopalakrishnan and Talluri, who are on trial in India.

It’s common for the global audit firms to want it both ways. When they promote themselves and their services to clients, regulators, legislators, and the media, they invoke the brand image of a “seamless global network of firms operating.

This is the bold title and introduction to Deloitte’s most recent Global Annual Review:

A Borderless Network

We all dream of the best future there can be.

For the clients and people of the Deloitte member firm network, it is one marked by excellence in client service, quality, accountability, distinctive talent development, innovation, and best-in-class practices. It is a future shaped by the unique capabilities and confidence of a global leader in professional services. And it is driven by the resources and commitments of a powerful, borderless network.

It’s sexier for the SEC to pick a fight with China to make political points about investor protection than to admit that the SEC and the PCAOB have not been monitoring the role the US firms play in audits of non-US based issuers audited by foreign member firms very well. The SEC also missed the boat on Longtop, in particular, and can’t blame the reverse merger loophole for letting a possible fraudster sell securities in the US. Longtop was a traditional listing. US regulators are making a habit of picking on the foreign member firms even when the issue is always integrity of the financial of US-listed companies. The regulators are giving the US firm, Deloitte US, a pass. That’s just like they did in the Satyam case. They did not hold the US audit firm accountable. They choose to ignore the charade of the global network concept.

There was ample evidence of significant involvement of PwC US in the negligent “no audit at all” at Satyam. The process of reviewing filings of foreign private issuers is the same at all large audit firms – the typically US based and US controlled GAAP and SEC reporting experts have to review everything – yet SEC will not push back on the US firm or hold them accountable for the quality of audits for US issuers.

The SEC’s pursuit of “paperwork” from Deloitte Shanghai is an exercise in futility. (All the records are electronic, anyway, and available in the firm’s global “cloud”.) The rules are changing in China and the audit firms there will be even more untouchable once they are Chinese owned and operated. That’s set to happen completely by 2017 as previous joint venture agreements with non-Chines partners will soon expire and the Chinese government is taking advantage of the opportunity to become even more nationalistic  – if that’s even possible – and expand the Chinese professional class rather than depending on foreigners to support its growth.

US regulators are criticizing professional services quality in China and the systemic corruption implied by frauds that include Chinese banks helping their corporate customers to falsify bank statements and account balance confirmations requested by auditors. At the same time, The Wall Street Journal is reporting “a landmark” decision by the Federal Reserve to allow three state-backed Chinese banks to expand in the US. Industrial & Commercial Bank of China Ltd., one of the world’s largest banking companies, will make the first acquisition of a U.S. retail-banking network by a state-owned Chinese lender when it buys 80% of the U.S. subsidiary of Bank of East Asia, a Hong Kong company with 13 branches in New York and California. The Fed also approved two Beijing-based banks, Agricultural Bank of China Ltd. and Bank of China Ltd., to build branches in New York City and Chicago, respectively.

The Fed better make sure they can walk into Chinese banks on US soil and inspect them.

With Democrats like Representative Carolyn Maloney of New York, who needs the Republicans? When special interests pursue self-interested legislation  – or seek to block legislation that affects their interests  – Maloney waves the jobs and economic growth flag for campaign contributors rather than defending investors.

Maloney voted for the JOBS Act in spite of the fact the bill destroys investor protections hard-won after the Enron fraud in the Sarbanes-Oxley Act. Maloney also recently spoke up on behalf of the audit industry instead of investors during a hearing held by the House Subcommittee on Capital Markets and Government Sponsored Enterprises. PCAOB Chairman Jim Doty testified about several agency initiatives to increase auditor independence, transparency, and accountability for auditors behaving badly. Maloney joined Republican Congressmen who pushed back hard on Doty and the PCAOB, the audit industry regulator, accusing the regulator of  “mission creep” and “overreach”.

Maloney represents Manhattan’s East Side and Queen’s West Side, the home of the financial services industry including the US headquarters of all of the Big Four accounting firms. Maloney serves on three key subcommittees of the House Committee on Financial Services because she, “believe[s] one of my chief tasks is to maintain the preeminence of New York City as the world’s financial center.” Maloney is “committed to defending the health of our financial institutions so that they can lead our economic recovery.”

But, in my opinion, she’s no expert on financial services or accounting policy.

Maloney’s real interests show up at the most inopportune moments. Back in 2000, before the Enron scandal, Richard Baker, a Louisiana Republican, ran the House Subcommittee on Capital Markets. He was very worried at the time about Fannie Mae and Freddie Mac. Baker saw the writing on the wall with the mortgage giants, behemoth Government Sponsored Enterprises (GSEs) that were eventually nationalized under a conservatorship in September of 2008 because of the significant losses they racked up from subprime mortgage securitization. Taxpayers are still paying the bill for the inattention by so many for so long to the accounting manipulation, fraud, and excessive risk taking at the GSEs that put both public companies into receivership.

Baker convened hearings and the undersecretary for domestic finance at Treasury at that time, Gary Gensler, offered his views during one of them on the Housing Finance Regulatory Improvement Act. Baker’s bill proposed removing the $2.5 billion line of credit available to Fannie and Freddie from Treasury. Gensler came out in favor of cutting off Fannie and Freddie. According to Gretchen Morgenson and Josh Rosner in their recent book, Reckless Endangerment, the Subcommittee on Capital Markets at that time was dominated by two factions.

“First were the “housers”—true believers in government subsidies for housing and supporters of Fannie and Freddie as the best vehicles to provide them. Equally zealous, though, were the members who received campaign contributions funded by the companies as well as the ribbon-cutting ceremonies for projects in their districts.”

As one of the most contentious hearings ended, Representative Carolyn Maloney piped up with a closing question for Franklin Raines, Fannie Mae’s chief executive, that seemed to ignore the point of the hearings – Fannie and Freddie were already overextended.

“I think it would be appropriate to bring the GSE structure to childcare, an area that has been failed by the private markets. I would like to know, would Fannie and Freddie be opposed to having the authority to buy childcare facility mortgages?”

Maloney’s quest to use the GSEs to fund childcare facility mortgages went nowhere in 2000. She sponsored variations of the bill repeatedly  in the following years. In 2006 it was called H.R. 5207, the Children’s Development Commission Act (Kiddie Mac). Maloney ignored what everyone else who was close to the financial services industry saw at that time: The mortgage industry was headed for a crash, led by subprime. By 2006, some of the big mortgage originators who fed Fannie Mae and Freddie Mac like New Century and Countrywide had started to falter.

These days Carolyn Maloney is pushing jobs and growth, growth and jobs, and protecting the interests of the venture capitalists, bankers, and “job creators” who woudl love to repeal the Sarbanes-Oxley Act. Maloney recently supported the Jumpstart Our Business Start Ups Act (JOBS Act) which goes a long way towards erasing the gains investors made in Sarbanes-Oxley.

Some Democrats who voted for the JOBS Act as a jobs bill, including Maloney, are now backpedaling.  ”I don’t see it as a great jobs bill,” Rep. Carolyn Maloney (D-N.Y.) told MSNBC’s Chris Hayes. “I don’t see it creating a lot of jobs.”

When Chris Hayes confronted Maloney with SEC Chairman Mary Schapiro’s objections to the removal of significant investor protections in the JOBS ACT, Maloney said Schapiro could write a letter to all Senators and Congressmen explaining her objections and they would consider a bill to address them.

Maloney also told the panelists that day, “I think it’s very difficult to take on the financial interests.”

I guess it wasn’t enough for SEC Commissioner Schapiro to send a letter with her concerns to the Senate Banking Committee before they took up the bill that the House passed with bipartisan support. That bipartisan support included votes from current House Committee on Financial Services ranking member Rep. Barney Frank, Rep. Maloney, and Rep. Maxine Waters. Rep. Capuano was the only Democrat voting no on this bill in committee.

In her letter to Senators Johnson and Shelby, SEC Commissioner Schapiro said the Jumpstart Our Business Startups (JOBS) Act, HR 3606, passed by the House would weaken investor protections by, for example, exempting emerging growth companies from the internal control audit opinion provisions of Section 404(b) of Sarbanes-Oxley. Schapiro believes the Section 404(b) internal controls requirement “has significantly improved the quality and reliability of financial reporting and improved investor protections and, therefore, believe this change is unwarranted.”

Instead of carefully considering growing public objections to the bill, the Senators expedited its passage instead. There was no bill mark-up session and no further hearings. SEC Chair Mary Schapiro did not testify and neither did any of the SEC Commissioners.

I attended the bill markup session for H.R. 3606, “Reopening American Capital Markets to Emerging Growth Companies Act of 2011″ by the House Committee on Financial Services on February 16^th.  Republican Congressman Garrett, the Committee Chairman, led a quick discussion of proposed amendments to the bill. Carolyn Maloney had none. In fact, Maloney was absent for much of the discussion because this was the same day as a Senate hearing on birth control. Maloney’s protests about, “Where were the women?” at that hearing dominated the evening news and play repeatedly as a video on her website. Instead of looking out for the investor, Maloney was focused on a soundbite and a photo op.

Maloney’s focus on women’s issues is the excuse given by many for giving her a pass on otherwise generally corporatist positions on everything else. As a woman and a progressive Democrat, I take Democratic legislators’ support for women’s health, anti-domestic violence, and pay equality issues for granted. I give Maloney no extra credit points for strongly supporting these initiatives. Maloney is a drive-by Democrat who does the warm and fuzzy blanket stuff and supports financial services and business legislation based on who has buttered her bread.

Maloney sought to repeal the protections of Sarbanes-Oxley early on. According to reports in the Huffington Post on October 28th, 2009, Rep. Carolyn Maloney sponsored the original bill to repeal SOx 404 internal control audit requirements for companies with market capitalization less than $75 million. This loophole applied to about 55% of publicly traded firms. Maloney’s amendment, co-sponsored with Rep. Scott Garrett, a New Jersey Republican, was to be attached to a bill pending in the House Financial Services Committee, the Investor Protection Act of 2009,.

The permanent exemption for companies under $75 million in market capitalization was passed under Dodd-Frank in July of 2010. The audit industry otherwise escaped any mention or sanction in Dodd-Frank, in spite of their failure to warn investors of problems at the bank who failed, were bailed out or acquired by healthier banks. In particular, legislation to repeal the exemption from aiding and abetting liability in securities litigation for third-parties like auditors never made it into Dodd-Frank.

Employees of KPMG, PwC, and Deloitte were among House Committee on Financial Services ranking member Barney Frank’s top 25 contributors leading up to the passage of Dodd-Frank, 2009-2010. During the 2008 election year, all of the Big 4 contributed to Frank’s reelection campaign.

The JOBS Act exempts “emerging growth companies” – that’s companies with up to $1 billion in revenue – from SOX 404(b) internal controls audits for five years or until they exceed the revenue threshold. That’s bad for the business of the accounting/audit industry. The additional provision that reduces required audits at the time of IPO filing for “emerging growth companies” from three years to two also takes food off auditors’ tables. The audit industry said nothing during the debate about the impact those provisions would have on investors. They would have appeared greedy. The auditors learned the hard way after the Sarbanes-Oxley Act was passed not to oppose public company executives who push for less regulation and less cost just because reducing investor protections may harm the true client – investors.  After all, it’s company executives and Audit Committees who hire auditors and their consulting and tax professionals and pay their bills, not shareholders.

Representative Carolyn Maloneycontinues to be a member of the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises. The latest incarnation, under the leadership of Rep. Garrett, recently held a hearing to discuss pending proposals and current challenges facing the auditing and accounting industries. (I guess the firms fal under this subcomittee because the audit firms are government sponsored enterprises by way of their exclusive franchise for providing stock exchange mandated and SEC mandated audits of public companies and because there’s a a stated “too few to fail” policy?)

Jim Doty, Chairman of the PCAOB, Jim Kroeker of the SEC, and Leslie Seidman of FASB answered questions from Committee members. Among the issues discussed was HR 3503, co-sponsored by Reps. Lynn Westmoreland (R-GA) and Barney Frank (D-MA) which would amend the Sarbanes-Oxley Act of 2002 to make Public Company Accounting Oversight Board disciplinary proceedings open to the public and a bill sponsored by Rep. Michael Fitzpatrick (R-PA) that would prohibit the PCAOB from mandating firm rotation. The bill, sponsored by Rep. Michael Fitzpatrick (R., Pa.), hasn’t yet been introduced.

The Wall Street Journal’s Michael Rapoport tells us:

According to data from the Center for Responsive Politics, which tracks campaign finance, Rep. Fitzpatrick has gotten major contributions from PricewaterhouseCoopers and Deloitte during the 2012 election cycle. PwC is his 10th-biggest contributor throughout his career in Congress, and the accounting industry has given him a total of $108,779 over his entire career.

Rep. Scott Garrett (R., N.J.), who is chairman the capital-markets subcommittee, has also benefited from the industry’s contributions. KPMG is his fourth-largest contributor throughout his career, and PwC is his 12th-largest. The accounting industry has given him $152,904 over his career.

Rep. Maloney is skeptical about the PCAOB’s request to make disciplinary proceedings against audit firms and auditors public. The Sarbanes-Oxley law bars the PCAOB from making such proceedings public unless both parties consent. That’s inconsistent with how the SEC handles similar sanctions against audit firms and auditors for violating securities laws. The PCAOB has said this allows audit firms to drag out legal proceedings for years while keeping audit committees and investors in the dark about auditor negligence and bad behavior.

“I understand the concern … but I also want to hear whether there is any concern that by making these proceedings public, we are unnecessarily harming the reputation of a firm before any official action is taken. Personally, I don’t think we should do so unless there is an official action taken.”

Maloney isn’t crazy about mandatory auditor rotation, either.

“Aren’t there other ways to boost auditor independence without putting in an arbitrary requirement that may disrupt the relationship between the firms and companies they audit?  It may affect the cost and quality of the audits, too.”

Those talking points could have come directly from the audit firms. In fact, they probably did.

“Mandatory firm rotation will not improve audit quality and its cost cannot be justified. “

PwC’s Bob Moritz in testimony to the PCAOB on March 21, 2012

“Ernst & Young…does not support mandatory firm rotation. In our view, it is not a necessary or constructive means to promote auditor skepticism, and we are aware of no evidence that it will improve audit quality…A mandatory audit firm rotation model would not only give rise substantial costs and disruptions, but would also impair audit quality and undermine sound corporate governance – all to the ultimate disadvantage of investors. We believe the mandatory re-tendering approach suffers from the same or even greater flaws.”

Steven Howe, Ernst & Young in testimony to the PCAOB on March 21, 2012

“Given the significant costs and disruption, the lack of evidence linking engagement tenure to audit quality, and, most importantly, the risk that mandatory rotation is actually a detriment to audit quality, we oppose mandatory firm rotation.

PCAOB enforcement proceedings currently are confidential under Sarbanes- Oxley, because Congress understood that auditors belong to a profession in which a good reputation is essential and publication of unproven charges may end an individual auditor’s career or audit firm’s existence.”

Barry Melancon, President of the AICPA, the audit industry trade organization, in testimony before the House Subcommittee on Capital Markets and Government Sponsored Enterprises, March 28, 2012

Maloney is at the top of the list of Democrats receiving campaign contributions from the auditors, second only to Brad Sherman of California, a CPA and Big Four alumni. Sherman has pocketed $49,500 from the industry already in 2012. Maloney, who counts the Big Four US headquarters amongst her district’s constituents, has accepted $28,500 in 2012. The accounting industry has given her $176,000 over her twenty-year career according to OpenSecrets.org, more than either Republicans Garrett or Fitzpatrick.

Looks to me like it’s the audit firm money, not Carolyn Maloney, doing the talking.

Last week was Groupon’s big week, although not in a good way. What happened? Well, the premier source of daily deal dish got knocked down a few more pegs after announcing a revision to 4th quarter earnings and the announcement by management that there was a material weakness in internal controls over financial reporting that was causing their disclosure controls to be ineffective. Groupon went public just a few months ago, last November, and the annual report was the company’s first filing as a public company.

Here’s one of the few journalists who got the details right, Jonathan Weil of Bloomberg, explaining why, in this case, the news was especially bad:

Didn’t Groupon know before its initial public offering that its controls were weak? A company spokesman, Paul Taaffe, declined to comment. Let’s assume for the moment, though, that its executives did know. Even then, they wouldn’t have had to tell investors beforehand.

That’s because there is no requirement to disclose a control weakness in a company’s IPO prospectus. Groupon would have had no obligation to disclose the problem until it filed its first quarterly or annual report as a public company — which is what it did. Sandbagging IPO investors in this manner is perfectly legal, it turns out.

The reason lies with a gaping hole in the Sarbanes-Oxley Act, which Congress passed in 2002 in response to the accounting scandals at Enron Corp. and WorldCom Inc. That statute had two main sections related to companies’ internal controls, which are the systems and processes that companies are supposed to have in place to ensure the information they report is accurate. Those provisions apply only to companies that are public already, not ones that have registered for IPOs.

One section, called 302, requires public companies’ top executives to evaluate each quarter whether their disclosure controls and procedures are effective. The other section, known as 404, is better known. It requires public companies in their annual reports to include assessments by management and outside auditors about the effectiveness of their internal controls over financial reporting. Congress left it to the Securities and Exchange Commission to write the rules implementing those provisions.

Here’s where it gets tricky. Groupon reported the weakness in its financial-reporting controls through a Section 302 disclosure, not a Section 404 report. In other words, the problem was serious enough that it amounted to a shortcoming in the company’s overall disclosure controls.

Groupon won’t have to comply with Section 404’s requirements until its second annual report, due next year, under an exemption the SEC passed in 2006 for newly public companies. Likewise, Groupon’s auditor, Ernst & Young LLP, to date has expressed no opinion on the company’s internal controls in its audit reports.

From the moment Groupon announced the revision on March 30, there were two important facts that almost all major media financial journalists got wrong:

1) The announcement of lower revenue and lower income for the fourth quarter was a revision of an earnings release, not a restatement. Groupon never filed a 10Q so there was no SEC filing to restate. Fessing up to the right numbers in the annual report was the first time the company was bound to report those numbers and, at that time, they corrected previously announced earnings for the 4th Quarter.

2) Management made the assessment of the material weakness in internal controls over financial reporting that caused disclosure controls to be ineffective, not auditor Ernst & Young. Ernst & Young deserves no credit for the announcement, nor any blame, just yet, for the fact that the weaknesses had to be finally admitted. There is no transparency regarding the auditor’s agreement or disagreement previously with Groupon, any public documentation of their discussions or any reason to believe Ernst & Young either encouraged or discouraged Groupon to get their act together sooner.

We just don’t know.

What we do know is that Ernst & Young signed the fourth clean audit opinion when it signed the audit report included in Groupon’s annual report. With the three audited financial statements included in the S-1, we can assume that control weaknesses Ernst & Young was aware of, if they were aware of any, were not serious enough in their opinion to qualify the audit opinion.

Because I was very busy with some other projects when the Groupon announcement came out I chose to be quoted regarding Groupon, rather than to blog about it, last week. I also tried to use Twitter to alert fellow journalists and the readers that the reporting had mistakes.

I was asked to comment on the Groupon story by three media outlets: the Marketplace radio program on PRI/NPR, Phil Rosenthal at the Chicago Tribune, and Crain’s Chicago Business.

I haven’t seen the story in Crain’s yet, but it Here’s the Crain’s link. It was nice to have two local media outlets notice they had someone who writes about these issues right here in Chicago where Groupon is based.

Marketplace’s Heidi Moore, who I follow on Twitter, wrote a short piece and my comment is strictly color. You can read the text and listen here.

The Tribune piece is extensive and Phil Rosenthal does a great job explaining why Groupon’s success or failure means a lot to the Chicago tech scene.  I get a long quote:

“As a Chicagoan, I’m really sad, because we’re proud when somebody does good here,” said Francine McKenna, an expert on the accounting and auditing industry who writes the Accounting Watchdog column for Forbes. “We love promoting our companies, especially homegrown success stories, and this is embarrassing.

“Because they’re growing so fast, because they’re trying to take a less conservative approach when they’re developing these numbers, because they want to shine the best possible light on what they’re doing, they got caught short. There was nothing they could do but admit they screwed up.”

To be honest, I’m holding back a bit on this subject because Groupon is a small part of a larger piece I’m wrapping up, hopefully, for the next issue of Forbes Magazine.  So let me make a few comments that did not make it to the magazine piece.

The role of the auditor, Ernst & Young, is confusing to experts, let alone the average investor or business reader.  Should the firm have caught Groupon’s errors before or after the IPO? Did Ernst & Young catch Groupon’s errors before the IPO and now?  Did Ernst & Young influence Groupon management’s decision to make the painful acknowledgement that they were caught short in the return reserves department and had to revise revenue and earnings? We’ll never know.

Here’s what Groupon management admitted in the annual report:

“…management concluded as of December 31, 2011 that our disclosure controls and procedures were not effective at the reasonable assurance level due to a material weakness in our internal control over financial reporting, which is described below.

In connection with the preparation of our financial statements for the year ended December 31, 2011, we concluded there is a material weakness in the design and operating effectiveness of our internal control over financial reporting as defined in SEC Regulation S-X. “

Groupon says they are deficient in:

• Controls over monthly financial close process and procedures
• Controls to insure accounts were complete and accurate and agreed to detailed support
• Controls over account reconciliations to identify errors and omissions in journal entries
• Controls over timely, effective review of estimates, assumptions and related reconciliations and analyses, including those related to customer refund reserves

That’s a lot of weakness. I find hard to believe these weaknesses only showed up in the last month or so of the year, after the IPO and multiple S-1 filings. Could Ernst & Young have stopped the IPO? Could the SEC have stopped the IPO?

One proposal that the audit industry regulator, the PCAOB, has on the table that could help in the future – but maybe not for pre-registration filings and auditor opinions – is the Auditor’s Discussion and Analysis. (The italics are my comments back to the PCAOB, the audit industry regulator under the SEC.)

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.

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 with each other.

Another factor to consider is the auditor’s responsibility right now with regard to disclosure or reporting of fraud and illegal acts – if errors and misstatements rise to that level even pre-IPO.  I’ve written previously that auditors are not very quick to tattle-tale on the executives of the companies they audit.  The audit firms prefer to work it out internally and over time. There’s just too much money at stake both as an auditor and as a consultant. We do not know what Ernst & Young’s fees from Groupon – or Zynga or Facebook – are yet.  The first proxies are not out.  But we do know how much money was at stake with some other clients that have had issues:

• Ernst & Young was paid more than $150 million in fees by Lehman for 2001 to bankruptcy in 2008 according to the New York Attorney General complaint against Ernst & Young for fraud regarding lack of disclosure of Lehman’s issues.
• Google paid Ernst & Young $13 million in 2010 and 2009. Google’s proxy did not explain how Ernst & Young could reduce its fee for audit services to this high-risk company by $1 million in 2010. Google is a serial subject of SEC investigations for its accounting for stock options and taxes. The company recently settled a Department of Justice criminal investigation over the illegal use of its AdWords program by Canadian pharmacies. Ernst & Young did charge Google $500 thousand more in 2010 to address those tax issues.
• UBS, home of a recent rogue trader scandal, paid Ernst & Young $63 million in 2011 for their the audit, $12 million for audit-related activities such as assurance and attest services, control and performance reports, advisory on accounting standards, transaction consulting including due diligence, and tax advisory.  Ernst & Young also earns another $32 million for services performed on behalf of UBS investment funds, many of which have independent fund boards or trustees.
• News Corp, where executives are accused of paying illegal bribes and hiding those payments on the balance sheet, paid Ernst & Young almost $35 million dollars in 2010 and about $31 million in 2009.  The increase equals about 10% more for more tax consulting services, which make up almost half – $16 million – of the total fees paid to EY by News Corp. That, to me, is a serious indictment of EY’s independence as auditor.

Getting back to Groupon and their erroneous earnings release and uncontrolled S-1s…

According to a recently published academic paper entitled, Pro forma disclosures, audit fees, and auditor resignations:

Pro forma disclosures are non-GAAP disclosures; however, under the provisions of SAS 8, auditors are still responsible for ensuring that no overtly misleading voluntary disclosures are released to investors. That is, auditors are required to review voluntary disclosures and prevent any misleading or overtly optimistic information from being released. In addition, auditors are potentially responsible for ensuring consistency of pro forma reporting in voluntary disclosures, such as press releases, with any pro forma numbers included in mandated disclosures, such as SEC 10-K or 10-Q reports (PwC Dataline 2010-03).

I know I expect the auditors to be earning their fees by looking out for investors. But maybe that’s just pie in the sky.

The video is Glen Hansard and Marketa Irglova singing “You must have fallen from the sky” from The Swell Season.

Original main page art from this site.

sciss

The Private Securities Litigation Reform Act of 1995 (Public Law 104- 67) added Section 10A to the Securities Exchange Act of 1934 (15 U. S. C. 78j- 1). Section 10A reporting requirements first became effective for fiscal years beginning on or after January 1, 1996.

The GAO[1] prepared a report in February 2000[2] and again in September 2003 at the request of Congress, regarding the audit industry’s compliance with Section 10A. The GAO also reported the statistics for SEC enforcement actions under Section 10A.

The February 2000 report stated that six Section 10A reports had been submitted by audit firms through December 14, 1999. Records from the SEC’s Office of the Chief Accountant show that during the period December 15, 1999 through May 15, 2003 – four years of turmoil in the markets and in the accounting industry – an additional 23 Section 10A reports were submitted.

From the inception of the 10A reporting requirement in 1996 through May 15, 2003, a total of 29 Section 10A reports were submitted to the SEC. The reports cover a variety of potential illegal acts, including improper revenue recognition, unusual capital transactions relating to stock warrants, inadequate financial statement disclosures, and failure to disclose expenses relating to stock options.

In the 2003 report, the AICPA attributed the low level of 10A reporting to the reasons they cited as stated in the 2000 GAO report: In most cases, management or the board of directors, often with the participation of internal or external counsel, took timely and appropriate action to address a situation involving an illegal act when it was brought to their attention by auditors.

According to SEC officials in 2003, all Section 10A reports from 1996 to 2003 were investigated. Of the 29 SEC registrants named in the reports as of 2003, 10 were the subject of active SEC enforcement investigations, 8 had actions brought against them by the SEC, and 11 reports were closed without formal action being taken by the SEC.

Injunctive actions and administrative proceedings were filed in 8 cases alleging violations such as (1) failure to disclose transactions in public statements to shareholders and the SEC, (2) inclusion of fraudulently- valued assets on financial statements filed with the SEC, (3) underreporting the value of inventory resulting in an understatement of expenses and liabilities and an overstatement of income, and (4) improper revenue recognition and understatement of expenses.

A violation reported under Section 10A may be closed without formal action being taken by the SEC because the registrant is no longer publicly traded, has a very small dollar amount of assets, or is no longer doing business. In certain instances, after discussions with the SEC, the registrants took remedial action, which the SEC found satisfactory, such as obtaining a review of the registrant’s quarterly financial statements filed with the SEC.

In 2002, the American Institute of Certified Public Accountants (AICPA) issued a new audit standard for detecting fraud, Statement on Auditing Standards (SAS) 99: Consideration of Fraud in a Financial Statement Audit. The AICPA believed SAS 99 would substantially change auditor performance, thereby improving the likelihood that auditors will detect material misstatements in financial statements due to fraud by placing an increased focus on exercising professional skepticism throughout the audit. The new standard required auditors to identify and consider risks of material misstatement due to fraud when planning and performing the audit through brainstorming among audit team members, inquiring of management, performing analytical procedures, considering inappropriate reporting of revenue and management override of internal controls, evaluating internal controls that address the identified risks of fraud, and assessing throughout the audit and at the completion of the audit the risk of fraud based on the results of auditing procedures.

The new standard also required auditors to communicate about fraud to management, the audit committee, and others, and to document the auditors’ consideration of fraud. SAS 99 was adopted and effective for audits of financial statements for periods beginning on or after December 15, 2002. The PCAOB, the regulator for the auditing industry established by the Sarbanes-Oxley Act in 2002, updated the standard the first time with Auditing Standard No. 5, adopted in 2007. The PCAOB revised the standard further in December 2010 as AU Section 316: Consideration of Fraud in a Financial Statement Audit.[3]

The Sarbanes-Oxley Act of 2002 also contains a number of provisions aimed at improving the quality of audits of public companies including more audit committee involvement with the auditor, a requirement for auditors to attest to management’s assessment of internal controls over financial reporting, a requirement for audit partner rotation, prohibition of certain non-audit services to audit clients, prohibition of providing audit services to a company that employs as a top official a previous member of the audit engagement team, and greater penalties for failure to report fraud.

Rule 240 10A-1 states that auditor reports under Section 10A must be submitted to the SEC’s Office of the Chief Accountant. The report must be in writing and identify the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. In addition, the report must include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements. The rule is based on the premise that the reports under Section 10A are supposed to assist the SEC in performing its enforcement responsibilities and therefore, the auditors’  reports are nonpublic.

After receiving and logging the Section 10A reports, the Office of the Chief Accountant forwards the reports to the Division of Enforcement, which conducts investigations into possible violations of federal securities laws and prosecutes the SEC’s cases. The reports are also forwarded to other divisions within the SEC, including the Division of Corporation Finance, which reviews the financial statements and other financial reports filed by SEC registrant companies. The Office of the Chief Accountant and the Division of Enforcement monitor the progress on any investigation initiated or facilitated by a Section 10A report.

Auditors are still getting used to an external regulatory regime under the PCAOB since 2002 versus the self-regulatory regime they operated under with the AICPA, their trade organization, as the rulemaker and enforcer. Frauds did not end after the Sarbanes-Oxley Law was enacted. It’s now apparent that fraud drove many of the financial crisis failures. The subprime crisis turned into a credit crisis then a full blown financial crisis. Major industrial and financial services companies in the United States and abroad were bailed out, forcibly acquired, and effectively nationalized in order to survive.

During that time, no warning bells for shareholders and society as a whole, in the form of “going concern” opinions, were sounded. As financial crisis litigation has increased, we are now seeing, almost four years later, the extent to which accounting fraud, disclosure fraud, and accounting manipulation played a role in these failures. We have also seen a record number of enforcement actions for illegal acts by corporations and individuals under the Foreign Corrupt Practices Act.

Section 10A is not mentioned very often in enforcement actions against auditors. Frankly, there are few enforcement actions against auditors at all compared to the number of enforcement actions against client company executives. But 10A has been mentioned recently on two specific occasions.

“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

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.”

Technically, this was not an enforcement action for, “failing to report likely illegal acts that have a material impact on a company’s financial statements,” but instead for failing to perform the audit in such a way that those illegal acts have a high likelihood to be detected. The SEC, and the PCAOB which filed a simultaneous enforcement action, chose to believe that PW India was ignorant of the illegal acts. The jury is still out, literally, in India, on whether the Price Waterhouse India auditors were aware of the illegal act, complicit in the fraud with executives, and did not report them or were simply incompetent as the SEC would lead us to believe.

On October 3, 2011, the PCAOB issued Staff Audit Practice Alert No. 8, Audit Risks In Certain Emerging Markets.

In the Alert, the PCAOB warned that although authorities in many emerging market countries were taking steps to improve investor protection, the PCAOB, “has observed from its oversight activities some conditions in audits of certain companies in emerging markets that indicate heightened fraud risk. Other situations have come to light in recent corporate filings with the Securities and Exchange Commission (“SEC”) and in SEC orders suspending trading in securities of certain companies in emerging markets.”

In just two months in 2011, more than 24 companies with their principal place of business in the People’s Republic of China (“PRC”) filed Forms 8-K with the SEC reporting auditor resignations, accounting irregularities, or both.[4] “In some instances, the auditor’s letter of resignation stated that the auditor resigned because of circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934 (“Exchange Act”).” [5]

The SEC took action, including instituting stop order proceedings against two PRC-based companies.[6] Additional auditor resignations, recorded on Form 8-K, have occurred.[7]

• How many of the auditors associated with the 24 companies with their principal place of business in the People’s Republic of China that filed 8-Ks also filed 10A reports? Did the auditors who mentioned, “circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934,” file 10A reports with the SEC?
• Did the auditors of the two PRC-based companies where the SEC issued stop order proceedings perform their duties under Section 10A or did they fail 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?
• Will we see any SEC enforcement actions against these auditors for failing to detect these illegal or fraudulent acts via proper audits and failure to report the illegal acts to the SEC?
• Did the auditors do their job in China?

Investors count on the auditors as the last defender of shareholder interests before regulators and the lawyers get involved. I wanted to see if the auditors had at least warned the SEC of potential frauds and illegal acts, in particular during the period leading up to the 2008 financial crisis bailouts.

I checked with the GAO in June of 2011 to see if anyone in Congress had asked for an update since 2003 on Section 10A reporting by auditors. Chuck Young, Managing Director of Public Affairs said, “No, we have not done any review since the one in 2003.”

So I prepared a Freedom of Information Act (FOIA) request in June and then again in October for the same information Congress and the GAO had previously requested from the SEC. The first request I made covered the entire period since the last report to Congress, 2003, until the present. It also referred to a tracking system that the 2003 report said would be implemented to help track these submissions by auditors and the SEC’s actions on them.

5) It was reported to the GAO in May 2003 that the Division of Enforcement was developing a computer tracking system for referrals of Section 10A reports, as well as complaints concerning possible financial reporting violations. Please attach any status reports that document the development progress and eventual implementation of this “computer tracking system”.

Unfortunately, the helpful response from the SEC to my initial request was that a request for data for the period May 16, 2003 through May 31, 2011 was too extensive, especially because the above referenced “computer tracking system” had not yet been implemented.

So I revised my request to cover just the years since January 1, 2007 as a start. The idea was to replicate the statistics the GAO had prepared, at least. If I could also see the underlying reports and data, all the better.

In December the SEC responded to my request, but refused to provide information about three of the four inquiries. They cited confidential treatment of investigatory materials or they told me to do my own investigating. I will appeal. I can also appeal to the House Financial Services Committee’s Subcommittee on Oversight and Investigations. Maybe the Congressmen will make a new request to the GAO to update this important oversight report since it’s not been done during the post-Sarbanes-Oxley era and now post-financial crisis period.

It’s quite surprising that the one substantive response from the SEC I did get was to my FOIA inquiry regarding the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.

The SEC replied that, “ a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.”

There are still many unanswered questions about how and why the financial crisis frauds occurred. New frauds, such as the Chinese reverse merger frauds, took advantage of a public listing loophole that the SEC and auditors missed. All these investor losses occurred under the supposedly watchful eyes of auditors, who are paid dearly to protect shareholders but in many cases are either complicit, incompetent, or both.

Dear SEC, Please send me the following records:

SEC Response:

As was mentioned in our letter of October 25, 2011, the FOIA was not intended to compel agencies to become ad hoc investigators for requestors whose requests are not compatible with their own information retrieval systems.[8] Nor does the FOIA require agencies to conduct legal research and answer questions disguised as FOIA requests.[9] Consequently, we have processed the portions of your request where responsive records exist; however, we did not process the portions wherein questions are posed.

(1)  Please provide the number of Section 10A submissions, by year, from January 1, 2007 through September 30, 2011 and a copy of each report filed that identifies the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. The filing should include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements.

(2)  Please provide the status of the SEC actions on those 10A reports that were filed, by year, between January 1, 2007 and September 30, 2011.

SEC Response: After consulting with Commission staff, we have determined the following: With respect to items 1 and 2 of your request, responsive records are withheld in their entirety under FOIA Exemptions: 5 U.S.C. § 552 (b) (3) and 7(A), 17 CFR § 200.80 (b) (3) and (7) (i).

The internal records which consist of material pertaining to Rule 240 10A-1 are protected form disclosure under FOIA Exemption 3. Exemption 3 permits the withholding of documents specifically exempted from disclosure by another Federal statute. Section 240.10A-1 states in part, that records submitted under this section, “shall be deemed to be an investigative record and shall be non-public and exempt for disclosure pursuant to the Freedom of Information Act to the same extent an for the same periods of time that the Commission’s investigative records are non-public and exempt for disclosure under among other applicable provisions, 5 U.S.C. 552 (b) (7) and 17 CFR 200.80 (b) (7).” See, 17 CFR § 240.10A-1.

In addition, with respect to on-going enforcement activities pertaining to any f the 10A submissions, the records are protected form release under Exemption 7(A), which protects form disclosure records compiled for law enforcement purposes, the release of which could reasonably be expected to interfere with enforcement activities.

(3)  Please provide the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.

SEC Response: With respect to Item 3 of your request, based on the information you provided in your letter, a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.

(4)  Please provide the number of 8-Ks filed for auditor changes each year 2007-2010 and the number of requests for additional information from the registrants as needed to clarify matters reported on 8-Ks for auditor changes.

During this period, did the Division of Corporation Finance identify any significant potential violations of SEC laws and regulations as a result of auditor changes, or forward any matters to the Division of Enforcement for further investigation? How many were identified or forwarded, by year January 1, 2007 to September 30, 2011?  Please include status reports of these investigations, if any.

SEC Response: Finally, with respect to Item 4 of your request, a significant portion of the information sought is publicly available on our website at www.sec.gov under the section “Filings and Forms.” Specifically, anyone can search the EDGAR database for Form 8-Ks filed during any year, and for staff comment letters and response letters for any filings filed during 2007-2010. The Commission does not maintain a retrieval system designed for culling data based on the information cited in your request.

[2] U.S. General Accounting Office, Securities Exchange Act: Review of Reporting Under Section 10A, GAO/AIMD-00-54R (Washington, D.C.: Feb. 4, 2000).

[3] The PCAOB was established pursuant to the Sarbanes-Oxley Act of 2002 (Act) to oversee the audits of public companies that are subject to the U.S. Federal securities laws. As provided for by the Act, the PCAOB will set professional standards (including auditing, attestation, quality control, ethics, and independence standards) to be used by public accounting firms registered with the PCAOB in the preparation and issuance of audit reports of public companies.

[4] See letter from SEC Chairman Mary Schapiro, dated April 27, 2011, to the Chairman of the House Subcommittee on TARP, Financial Services, and Bailouts of Public and Private Programs, Congressman Patrick McHenry, at http://s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf.

[5] See the discussion in the section in the PCAOB Alert on illegal acts.

[6] See SEC Press Release, Stop Order Proceedings Instituted Against China Intelligent Lightning and Electronics, Inc., and China Century Dragon Media, Inc. (June 13, 2011) at: http://www.sec.gov/news/press/2011/2011-127.htm

[7] See, e.g., Longtop Financial Technologies Limited, Form 6-K (May 23, 2011), Exhibit 2 at: http://www.sec.gov/Archives/edgar/data/1412494/000095012311052882/d82501 exv99w2.htm.

[8] Blakey v. DOJ, 549 F. Supp. 362, 366-367 (D.D.C. 1982).

[9] Satterlee v. IRS, No. 05-3181, 2006 WL 3160963, at *3 (W.D. Mo. Oct. 30, 2006).

Main page photo source: Adventures of a Ghanian

It’s difficult for me to imagine a new generation of systemically important financial services company CEOs without strong risk management experience. Independent board members with risk management experience will also be in demand. The current generation of CROs is gaining the experience to lead as CEOs and board members in today’s challenging market and regulatory environment.

Stewart Goldman, a senior client partner at executive search firm Korn/Ferry International, tells me there’s a ‘’scarcity” of candidates with the ”ideal skill set” to be chief risk officers, so institutions are considering people with a broader range of backgrounds to fill the post.

A Chief Risk Officer who does a good job mitigating risk while optimizing opportunities can now have significant stature and sway. But, conversely, that new prominence gives shareholders, regulators, and the media an easy target for ridicule after a corporate stumble or failure.

I’ve written quite a bit about some additional cases of Chief Risk Officers getting the heave-ho when something goes wrong. These additional examples – all outside of the US – didn’t make it to the American Banker column. It was a case of space as well as an “American” banker focus. But, I wonder out loud if there’s something different going on in Europe – something that forces accountability – or if the executives given the shove-off in Europe were just easy scapegoats.

Société Générale had its own “rogue trader” scandal in January 2008. Société Générale  lost $7 billion in spite of service from dual auditors under French law, Ernst and Young and Deloitte, and myriad policies, procedures, organizations and systems they, theoretically, had in place to manage risk.

However, words alone do not insure sufficient risk management. In 2009 Benoît Ottenwaelter replaced Group Chief Risk Officer Didier Hauguel. Hauguel had served as Group CRO and a member of the Executive Committee and Group Management Committee of Société Générale since 2000.

Paul Moore, HBOS’ former head of regulatory risk and a former KPMG partner told the Treasury Committee of the UK’s Parliament that Sir James Crosby, HBOS former chief executive, fired him after he warned the HBOS board in 2004 about its potentially dangerous “sales culture”. KPMG, external auditors for HBOS, ended up front and center in the 2004 controversy because the audit firm “independently” investigated Moore’s firing at the request of the Board after Moore blew the whistle. KPMG got the job in spite of its long and very lucrative relationship with HBOS management including significant fees for work done for the bank’s bid for Abbey National that same year.

The role of chief risk officer at Anglo Irish Bank, a tough job, has not been filled on a permanent basis since May of 2009. AIB was nationalized by the Irish Government in January 2009. In December AIB lost its second acting chief risk officer in less than a year when Stephen Bell, a PricewaterhouseCoopers Director, announced he was leaving to become Chief Risk Officer at Ulster Bank. AIB had hired PwC to help run the bank. Bell took over from Mary Phibbs, an associate at restructuring firm Alvarez and Marsal, who had been on the job since the previous October.

One interesting additional US example can be found at Countrywide, now ignominiously owned by Bank of America. I wrote about it in January of 2008.

At the end of 2004, Sherry Whitley, then the Executive Vice President of the Enterprise Risk Assessment Group for Countrywide, wrote this article for the Institute of Internal Auditors FSA Times Publication.

Countrywide’s strategic-planning process includes a companywide focus on managing risks.

In the wake of headline-grabbing corporate financial scandals, management and boards of directors of public companies are under intense pressure to increase their involvement in the strategic and operational activities of the companies they oversee. Executives at Countrywide Financial Corporation, a diversified financial services provider, reviewed various ways to provide a more focused, comprehensive approach to help their leadership teams identify and better manage business risk across the organization.Approaching risk with the goal of increasing shareholder value, in mid-2002 Countrywide incorporated comprehensive enterprise risk-management techniques into its leadership strategy, focusing board participation on a more global, disciplined decision-making process than has historically been used in the past.

In 2007, the Institute of Internal Auditors and their Research Foundation, lauded Countrywide’s Risk management initiative.

Countrywide Financial Corporation, the subject of our first case study, has the most comprehensive ERM program we have seen. Readers who want to know how a state-of-the art ERM program operates will see it illustrated through Countrywide’s example.

A writer for Internal Auditor magazine, an IIA publication, wrote in April of 2007 about this model initiative.

The largest independent originator and servicer of mortgage loans in the United States, Countrywide has the most comprehensive ERM program of the organizations in the study. Under the leadership of Senior Managing Director Walter Smiechewicz, Countrywide is currently building Sarbanes-Oxley functionality into an internally developed enterprise risk assessment software application…Countrywide’s Enterprise Risk Assessment division has 45 professionals with risk assessment responsibilities. They are supplemented by 112 internal auditors within the Enterprise Risk Assessment division and the risk management specialists in another division who manage credit and market risk for Countrywide…Enterprise risk assessment at Countrywide has both a bottom-up and top-down governance structure. It has led to a major restructuring of committees from the board level down through operating units. This restructuring has improved the flow of risk information throughout the organization…Countrywide’s program is truly “best practice…”

Things didn’t get any better when Bank of America tried to close the deal on Countrywide. In March of 2008, I reported that Bank of America was staring down a very dark tunnel on Countrywide exposure:

Just who is doing the due diligence for Bank of America on the acquisition?

Countrywide’s Mortgage Woes Deepen
Countrywide Financial Corp.’s mortgage portfolio continues to deteriorate rapidly as defaults increase and home prices fall, a securities filing shows…But if losses on the loans exceed certain levels, Countrywide isn’t reimbursed immediately and may never be reimbursed unless income from the loans outstanding is sufficient to meet obligations to investors in the securities.

Countrywide said the likelihood of such a situation was “deemed remote” until late 2007. It blamed a “sudden deterioration” in the housing market. As a result, it recorded a $704 million loss to cover the estimated costs of its obligations on the lines of credit…A Countrywide computer model used to gauge risks on these securities didn’t take into account the possible effects of exceeding the loss levels that cut off reimbursements, according to a Dec. 28, 2006 internal report reviewed by The Wall Street Journal.

I can’t find any mention of Sherry Whitley, former Executive Vice President of the Enterprise Risk Assessment Group for Countrywide, working at Bank of America or anywhere. Walter Smiechewicz, who implemented Countrywide’s ERM program, moved to Audit Analytics in 2008 and is now Chief Risk Officer at First Niagara Bank in California.

Bob English, an independent trader and contributing editor to the blog, Economic Policy Journal, wrote earlier Monday about some filings funny business over at the SEC.

On January 3, 2012, a copy of the missing audit reappeared under a different index number (the original, as of the time of writing, remains here). While it seems the replacement simply corrects what is an obviously wrong stamped receipt date on the face page of the original, there are a few curious annotations that we will explore. More importantly, after researching the SEC’s public database for scanned paper filings, which includes private offering Form D’s, exchange filings, firm advertising literature, and other filing types (including broker dealer audits themselves), we are left with more questions than answers.

It seems that sloppy scanning and filing standards combined with preferential treatment for certain large brokers has substantially reduced the value of this part of the SEC’s public filing system…a look into all of 2011’s scanned paper filings reveals that only 45% of the sequentially indexed PDF files that were scanned from hard copies by the SEC remain public (7,949 out of 17,718). [The SEC has kindly left the source code to its PDF scrubbing program here, also archived here on Scribd.]

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.

These disclosures were a result of pressure brought to bear by Congresswoman Maxine Waters and several other congressional members who sent a letter to the OCC and the Fed on October 28. This letter expressed the legislators’ displeasure with the way the OCC and the Federal Reserve Bank had so far run the “independent” foreclosure review process that is intended to overhaul mortgage-servicing processes and controls and to compensate borrowers harmed financially by wrongdoing or negligence.

Congresswoman Waters cited my October 6 column for American Banker in this letter to the OCC and Fed when demanding that the regulators manage conflicts of interest in the foreclosure review process as well as make a full disclosure of vendors and their engagement letters with the banks.

On December 6, I wrote again in American Banker after I reviewed the engagement letters that were posted by the OCC. I had several concerns. Congresswoman Waters did, too.

“[The OCC] issued a report on the actions of a dozen national bank and federal savings association mortgage servicers aimed at complying with the consent orders issued in April 2011 to correct deficient and unsafe or unsound foreclosure practices. (The two remaining consent order recipients — GMAC/Ally and SunTrust — have not yet finalized their terms with vendors and as a result their overseers, Fed Chairman Bernanke and the Federal Reserve Bank, have not yet responded to the request for full disclosure, according to the Water’s office.)

Waters was less than impressed with what she saw and so am I.  She told me, “My letters specifically asked for information on conflicts of interest between the banks and the consultants — which is precisely what the OCC redacted in the information they released last week. A cursory look into the banks and their consultants indicates that in some cases, there are substantial pre-existing relationships between the firms.”

Redacted is an understatement.

Here’s what was redacted, according to OCC spokesman Bryan Hubbard:

Limited proprietary and personal information has been redacted from the engagement letters including, but not limited to:

• Names,titles and biographies of individuals;
• Proprietary systems information;
• References to specific bank policy;
• Fees and costs associated with the engagement;
• Specific descriptions of past work performed by the independent consultants.

So what’s left? It’s interesting enough, as a start, to look at which consultants and law firms were selected by which servicers. It’s also interesting to look at the scope of services to be performed and the time and volume estimates for project activities where they were not redacted.

From my December 6 American Banker column:

The disclosure of the consultant engagement letters for each servicer has already had a huge impact. The Financial Times reports that the New York Attorney General “launched an investigation into possibly unlawful foreclosureson the mortgages of active-duty members of the US military.” The foreclosure review engagement letters posted by the OCC included estimates prepared by the banks and their consultants suggesting, according to the Financial Times, that 10 leading lenders may have seized the homes of about 5,000 service members in violation of the Servicemembers Civil Relief Act, which restricts foreclosures on the homes of active duty members of the U.S. armed forces.

There’s also the issue of attorney-client privilege:

Some of the engagement letters invoke attorney-client privilege and attorney work product privilege over the whole process and confidential treatment of engagement letter itself. It appears all the servicers used their general counsel’s office to engage the consultants and outside counsel and some name their general counsel as project lead. Some servicers engaged additional outside legal counsel for the review directly rather than through the primary consultant.

OCC spokesperson Hubbard says, “although some of the engagement letters make claims of attorney-client privilege, these claims are by statute inapplicable to the OCC and FRB, which have complete access to all documents produced by the independent consultants and servicers as part of the independent foreclosure reviews required by the Consent Orders.

I certainly hope so.

I was the first to report on December 6 the irony of Deloitte having been selected by, of all banks, JP Morgan Chase. The high likelihood of a conflict between the bank and the audit firm, and possibly the individual Deloitte partners assigned to the JP Morgan Chase review, should have been obvious to anyone at the OCC. I said on December 6 that it would be great if we could see the names of the partners and staff assigned to the engagements and check their credentials and prior client work for conflicts.

It would be enlightening, for example, to see whether any of the Deloitte partners proposed as consultants as part of the foreclosure solution at JP Morgan/EMC, were previously part of the mortgage origination/securitization problems as auditors at Bear Stearns or Washington Mutual.

Bear and Washington Mutual, both former Deloitte audit clients, are now part of JP Morgan Chase, and Deloitte is defending lawsuits over alleged audit failures at those firms.

Lo and behold, partner Ann Kenyon of Deloitte, who testified at a December 13th Senate hearing on the issue, said under oath that she is the engagement partner on the JP Morgan Chase foreclosure review. An internet search revealed a conference biography that suggests that amongst Kenyon’s representative clients was Washington Mutual, now owned by JP Morgan Chase and a significant part of the review. This would be a clear conflict with her role as engagement partner for the review.

Ms. Kenyon [who leads Deloitte's Securitization Advisory practice] works with issuers, comprised of both attest and non-attest clients, who have encountered difficulties in accounting for and reporting on their securitizations.

At the 126:20 mark of the archived webcast of the Senate hearing Kenyon describes the organizational structure, level of experience and source of professionals for the Deloitte JP Morgan Chase review team. (She says it’s all Deloitte staff.) She also says that a large team of Deloitte partners who are subject matter experts report to her and are leading each team.

Someone should check their conflicts, too.

Two of the other three Big Four audit firms were selected for multiple review assignments. KPMG, auditor of Citigroup, New Century, Countrywide, Wells Fargo, and Wachovia, is conspicuously but thankfully absent from the list of consultants.

Examples of firms involved in multiple reviews include Ernst & Young (involved in three reviews as both a primary consultant and subcontractor), PricewaterhouseCoopers (involved in two reviews as a primary consultant), and Promontory Financial Group (involved in three reviews as primary consultant). Law firm Gibson Dunn is legal counsel for three reviews (retained by the consultant in two cases and by the bank directly in one).

For example, one firm could be charging different rates to different banks for what is supposed to be a consistent review across servicers. That not only indicates banks can leverage their influence with vendors to get the review they want (and the monetary exposure estimate) at the price they want to pay, but that we may not get consistent results for borrowers that were harmed by multiple servicers.

Some of the concerns I mentioned in my December 6 column were pursued by Senators at the December 13 Senate Committee on Banking, Housing, and Urban Affairs hearing: Helping Homeowners Harmed by Foreclosures: Ensuring Accountability and Transparency in Foreclosure Reviews.

Some additional interesting interchanges during the hearing:

At the 45:30 mark of the archived webcast, Senator Reed asks the OCC’s Julie Williams why the OCC and Fed could not select and contract with the consultants directly. Williams says that would have been difficult because it would have necessitated the regulators to use a “procurement process” that included consistent “standards” for selection.

That sounds to me like a Request for Proposal process and a vendor selection process that is in place  - for many of these same vendors already – as a result of the finical crisis. Instead the OCC and Federal Reserve bank abdicated the vendor selection process to the services and, therefore, will reap the numerous potential conflicts they have sown.

At the 49:00 mark, Senator Reed asks a critical question, perhaps thinking about the Deloitte/Bear Stearns-EMC/Washington Mutual issue with regard to a JP Morgan Chase review. If a consultant runs across a set of transactions that the firm or those consultants had direct involvement in is the consultant obligated to report that conflict to the regulator?  Williams says that they would expect to hear about such a conflict.

Reed presses to ask if there is an “obligation” versus an “expectation”.  Williams sounds evasive in her answer, implying that this specific obligation is not explicit in the engagement letters.  I sure didn’t see it.

My December 6 column, in particular the parts regarding the Deloitte conflict and the attorney-client privilege issue were mentioned in the written and oral testimony by Alys Cohen, Staff Attorney  at the National Consumer Law Center.

With regard to the attorney-client privilege potential issue, the OCC and the Federal Reserve Bank should make sure all legal counsel that is intended to be part of the foreclosure review team should be retained by the consultant not the bank.  Otherwise, I see an assertion of attorney-client privilege by the outside legal counsel for the reviews as inevitable.

Some additional areas where strong monitoring by Congress and the OCC/Fed might be helpful going forward include:

• Checking consistency of level of effort estimates across project plans for each consultant’s proposal. Estimated hours for each task may vary based on the size and complexity of servicer, difficulty of obtaining information, and level of cooperation in resolving issues. But consultants will bill on a “time and materials” basis and variations in length of time estimated, for example, for each initial loan review and the quality assurance process could make millions of dollars of difference in fees given the tens of thousands of documents to be reviewed.

• The complaints process, managed as a coordinated approach for all servicers by Rust Consulting, needs to be synchronized with each servicer’s plan for their reviews. Although the OCC strongly influenced the design and implementation of the “coordinated” process, Rust Consulting signed a contract each servicer, risking the possibility of some servicers skimping on the effort or being unprepared based on their lack of progress in other dependent activities.

The PCAOB, the audit industry regulator, shamed global audit firm Deloitte recently when they exposed the private portion of the inspection report of the firm’s 2006 audits. It was the first time that had happened to one the Big Four audit firms, the largest firms that audit the vast majority of publicly listed firms in and out of the U.S..

I’m sure Deloitte, and the rest of the Big Four, thought the PCAOB would never have the nerve.

re: The Auditors has seen a confidential, internal Deloitte training document, prepared this past summer, that reveals the firm expects the worst when the inspection reports for their 2009, 2010, and 2011 audits are published by the PCAOB. The 2009 report should be out by the end of this year. The training document also shows how difficult it is for Deloitte leadership to steer the largest global firm away from the “audit failure” iceberg.

It seems audit competence and capacity to audit complex topics are in short supply at all the firms, based on PCAOB inspection results for audits conducted during the financial crisis period and the reports for 2010 audits at PwC and KPMG released recently. Deloitte has been particularly hard pressed to maintain audit quality since the firm lost several engagements that would have helped to grow specialized knowledge and retain experts. Big clients like Merrill Lynch, Bear Stearns, and Washington Mutual helped pay the bills for subject matter experts and quality control but those revenues were lost to financial crisis failures and forced combinations with better capitalized, non-audit client banks.

I think the PCAOB decided to publicly criticize Deloitte for two reasons.

• The firm has been piling on the negatives via a $1,000,000 fine/disciplinary sanction as a firm for a previous issue, two high level insider trading scandals (Flanagan and McClellan), the failures and frauds of Deloitte China clients CCME, Longtop and now Focus Media, and the specific failures of major clients during the crisis (Bear Stearns, Merrill Lynch, WaMu, Taylor Bean & Whitaker, American Home, and Royal Bank of Scotland, to name a few).
• Deloitte was resistant to the inspections, resistant to the criticisms, and unwilling to make changes based on the PCAOB’s requests. If you can’t fix something that’s one thing. If you won’t and thumb your nose at the regulator, you are getting close to Arthur Andersen-like behavior.

We know how that story ended.

If they did nothing, the PCAOB risked having a new major failure of a Deloitte client expose their lack of push on the firm to even respond, let alone improve.

I wrote in American Banker about the special risks to financial services firms when the regulated, like Deloitte, resists the regulator:

The PCAOB’s decision to make the Deloitte 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.

These risks apply to all of Deloitte’s clients and to all public companies if the rest of the firms – KPMG, PwC, and Ernst & Young – are also playing chicken with the regulator.

A little more than a month after releasing the Deloitte private report, the PCAOB released the inspection reports for audits performed by PwC and KPMG in 2009. The Financial Times’ Kara Scannell summarizes the findings:

The Public Company Accounting Oversight Board’s findings from an annual inspection revealed that years after the financial crisis both auditing firms were not adequately challenging companies’ valuations of certain assets when the market for them dried up…

The board reviewed 71 audits completed by PwC in 2010 and 52 audits done by KPMG in 2010.

The Wall Street Journal’s Michael Rapoport tells us how bad the results really were:

The government’s auditing regulator found deficiencies in 28 audits conducted by PricewaterhouseCoopers LLP and 12 audits by KPMG LLP in its annual inspections of the Big Four accounting firms.

The Public Company Accounting Oversight Board said many of the deficiencies it found in its 2010 inspection reports of the two firms, released Monday, were significant enough that it appeared the firms didn’t obtain sufficient evidence to support their audit opinions.

The regulator hasn’t yet issued its yearly reports on its inspections of the other Big Four firms, Ernst & Young LLP and Deloitte LLP.

KPMG’s response to the PCAOB was not quite as belligerent as Deloitte’s persistent irritation at having their “professional judgment second-guessed”. But, it was not exactly conciliatory.

Floyd Norris of the New York Times:

Normally these letters say something like what KPMG wrote:

“We conducted a thorough evaluation of the matters identified in the draft report and addressed the engagement-specific findings in a manner consistent with PCAOB auditing standards and KPMG policies and procedures.”

You may note that said nothing about whether the firm accepted the board’s conclusions or not. That is better than what Deloitte did a few years ago, when it essentially said the board did not know what it was talking about.

PwC, on the other hand, met the regulator more than half way according to Norris:

PwC’s letter addressed that issue, saying that while there were cases where it differed with the board’s conclusions, “they generally related to the significance of the finding in relation to the audit taken as a whole, and not to the substance of the finding.”

“Accordingly,” wrote the PWC officials, “the overall PCAOB inspection results, as well as the results of our internal inspections, were important considerations in formulating our quality improvement plan,” which it then describes.

PwC’s spokesperson sent me this additional statement:

“PwC is built on our reputation for delivering quality. We also recognize that the role we play in the capital markets requires consistent, high-quality audit performance. We therefore are focused on the increase in the number of deficiencies in our audit performance reported in the 2010 PCAOB inspection over prior years. We are working to strengthen and sharpen the firm’s audit quality, including making investments designed to improve our performance over both the short- and long-term.”

Did the quality of the auditing really deteriorate for KPMG and PwC or is the PCAOB getting tougher, and maybe better, at what they do?

We’ll have to see what the upcoming Ernst & Young and Deloitte reports show. Ernst & Young has been criticized for the Groupon multiple S-1 issue, as well as questions about accounting at future IPOs Zynga and Facebook. Now we have Olympus, too. And, of course, the jury is still out on the firm’s role in Repo 105 and Lehman Brothers.

And what about the Deloitte improvement plan for prior years? Has Deloitte accepted the PCAOB’s criticisms and moved on or are they still fighting the regulator? Is Deloitte working hard to get ahead of their 2009, 2010, and 2011 results and avoid the embarrassment or worse – sanctions – if the PCAOB has to publish another private report?

The confidential internal training report, intended to brief Subject Matter Resources (SMR), is called, “FY 2012 Engagement Quality Activities”.

The Audit Quality Activity Plan for FY2012 has been socialized with:

1. –  The OAQ Steering Committee
2. –  The Audit Quality Council
3. –  The RMPs
4. –  The NPPDs
5. –  The RILs
6. –  Leaders in the PPN
7. –  Extended Leadership Team
8. –  CFO / CEO

Yeah, that’s a lot of acronyms. And I’m not sure anymore – maybe I’ve been out of the firms too long or maybe I was never in them enough – what “socializing” a quality plan means. Suffice to say, the document, one hundred and eight-one very dense PowerPoint pages, has tons of information for the SMRs to absorb and pass on to engagement teams like now.

But, by this summer, it was too late to make a difference in the inspection reports for the 2009 and 2010 audits.

2009

• Response submitted on May 4

2010

• Total of 98 comments (56 engagements inspected)
• Expect about 25 engagements to appear in Part I
• Draft report has not yet been issued

2011

• 33 engagements selected to date
• Focus areas
  – Continue to include: fair value and impairment determinations; internal controls – Also focusing more on revenue recognition
• 16 completed
  – 5 with no written comments
• Total of 24 comments on 11 completed inspections

If Deloitte sent their response to the PCAOB for the 2009 audits on May 4th, why are we still waiting for the final report? Given the PCAOB’s decision to release Part 2 of the inspection report for Deloitte’s 2006 audits last month, I believe Deloitte was still treating PCAOB comments as an affront to partners’ professional judgments.

What are the root causes for so many negative PCAOB comments, according to Deloitte?

When evaluating “what didn’t work” for the various engagement activities, the consistent refrains outlined in the training document are “started too late”, “not enough time”, and “greater discipline and consistency needed”.

But there’s a bigger problem when it comes to audit failures around complex topics like goodwill, deferred tax asset impairment, fair value determination of thinly traded securities, and management estimates of loan loss reserves. There’s a huge intellectual divide between the audit teams and the subject matter specialist teams.

Professionals who are experts in tax or valuation of complex derivatives, for example, are not experts in auditing standards. The auditors, and the education they receive in universities and in the firms, focuses on the technical aspects of accounting – they know GAAP chapter and verse but not GAAS. That’s how we ended up with a defense of Repo 105 from Ernst & Young that the treatment meets the GAAP requirements with no appreciation for the more subtle GAAS disclosure expectations. Until recently, the firms didn’t think the PCAOB would push them to meet such high standards for auditing as long as the accounting was, subject to “professional judgment”, right enough.

But that’s how the auditors missed, or justified looking the other way, as so many banks failed or had to be bailed out during the crisis. This attitude is evident when you read in the training document how many of Deloitte’s policies and methodologies have to be revised to now absolutely require certain tests and additional steps. The steps weren’t performed unless the firm considered them explicitly required. Unfortunately, there’s still a difference of opinion between Deloitte and the PCAOB about what the PCAOB auditing standards explicitly require.

Here’s one example from the Deloitte training document:

Auditing Standard No. 12 – Identifying and Assessing Risks of Material Misstatement

Understanding the company and its environment

Change to our Methodology: We shall consider reading public information about the company (e.g., analyst reports), observing or reading transcripts of earnings calls, obtaining an understanding of compensation arrangements with senior management, and obtaining information about trading activity in the company’s securities. (AS 12.11)

Key Takeaway: This is a more specific requirement for audits performed in accordance with the standards of the PCAOB. Previously, while we may have been considering these items in our audits, their consideration was not explicitly required by our policies or by professional standards.

How does Deloitte intend to meet this higher standard in a quick and dirty, cost effective way?

Run a report using “OneSource” that includes a company summary, corporate overview, strategic initiatives, strengths & weaknesses, competitors report, significant developments), News, Articles and Financial Statements.

Zippity doo da.  You now know everything you need to know about the company.

It doesn’t help that the audit firms business model accepts high turnover of staff during the first 5 years. It’s a model that auditors got away with when issues were not as complex as they are now, especially within financial services firms.

For example, how can a senior, someone with 2-4 years experience, test a complex structured derivative for potential fraud (i.e. think of the Abacus deal) which is, in reality, an embedded derivative with multiple tranches and economic and risk characteristics that may not be aligned with the host, sitting off balance sheet, after having been passed thru an SPV sponsored by a “too big to fail” bank?

The manager, senior manager, and partner typically have no idea what the subject matter expert, a member of Deloitte’s Financial Instrument Valuation Risk Analytic team, is talking about when he says the client’s models and assumptions are insufficient, outdated, or flawed. The audit team probably doesn’t even know what a synthetic CDO is.

The most egregious recent example of a subject matter being ignored  - it happened in Enron, too – is the case of KPMG’s expert on mortgage securitizations and repurchase risk being told, “We’re done here” when he warned at New Century Financial that the client’s models had obsolete assumptions. That ugly episode only came to light because of the New Century bankruptcy and a robust bankruptcy examiner’s report.

In the recently disclosed Part 2 of the 2006 Deloitte inspection report, the PCAOB told the firm that partners were ignoring experts, too.

The inspection team identified six engagements where there were deficiencies in the procedures relating to the use of the work of specialists. These deficiencies included five engagements where there was no evidence in the audit documentation, and no persuasive other evidence, that the Firm had tested certain data or assumptions that the issuer had provided to the specialist (beyond, in one instance, inquiry of management).

In the sixth engagement, as part of their tests of the issuer’s annual goodwill impairment test, the Firm’s internal valuation specialists performed various sensitivity analyses to resolve concerns the specialists had raised regarding the issuer’s method for evaluating goodwill. For some of the issuer’s reporting units, the sensitivity analyses indicated the fair value of the unit might be considerably lower, or considerably higher, than the unit’s carrying value. The Firm failed to perform further, more precise sensitivity analyses, or other procedures, to determine whether the goodwill associated with these units was impaired.

Deloitte did not use its specialized SEC reporting and GAAP/IFRS consultation group well either.

The inspection team identified complex fact patterns in significant accounting and auditing areas, which were associated with deficiencies noted in seven engagements,35/ including five engagements36/ discussed in Part I.A, where the engagement teams did not consult with the Firm’s National Accounting Research or Quality Assurance departments. In addition, * * * * engagement teams consulted in three instances at below “Level A,” and neither the engagement team nor the National Accounting Research personnel raised the issue to a higher level as allowed by the policies.

Is Deloitte truly committed to a sea change in tone as well as technique? Seems to me the firm puts an enormous burden on the “soldiers” on the front lines and not enough on the “generals”, the partners who sign the opinions.

I’m not convinced they’re committed. Based on this document, and insider reports, I believe the the firm is still resistant. The firm’s big hope is probably that the spotlight moves away from Deloitte when something happens at another firm. Perhaps it will be a new development in the New York Attorney General’s case against Ernst & Young for Lehman.

But I do think the PCAOB is getting bolder and won’t be letting up on the audit firms.  The recent inspection reports on PwC and KPMG 2009 audits are proof of this.

Here in Chicago, everyone is mad and no one knows who has the answers.

MF Global’s auditor is PricewaterhouseCoopers, who inherited the client when Man Financial, also a client, spun off the brokerage firm in 2007.

Almost everyone wondering where the missing MF Global customer assets have gone thinks they will show up eventually.

I believe the assets are long gone.

Unlike the shell game, there is no bean under the MF Global dixie cup. The mixed bag of marketable securities taken from customer segregated accounts, used most likely to meet margin calls and satisfy “important” customers closing accounts during the last days, will, in my opinion, never be seen again.

Too much time has passed for anyone to still reasonably expect that the “discrepancy” is just a timing difference or a misallocation between accounts, according to several sources who prefer to remain anonymous because of the sensitivity of the situation. All of the statements made on the record by those in a position to know point to assets taken out of the firm and now gone for good.

CFTC in bankruptcy filing October 31 according to The Financial Times: The CFTC, in a court filing, revealed MF Global’s general counsel Laurie Ferber emailed the regulator at 7.18pm Monday – hours after the bankruptcy filing – to say that it had “discovered a significant shortfall in its segregated funds account”.

Joint statement of CFTC and SEC on November 1: “Early this morning, MF Global informed the regulators that the transaction had not been agreed to and reported possible deficiencies in customer futures segregated accounts held at the firm.”

The CME Group on November 2: “CME completed its on-site review last week. [Reportedly Monday.] At that time, the results of our review indicated that MF Global was in compliance with its segregation requirements.  It now appears that the firm made subsequent transfers of customer segregated funds in a manner that may have been designed to avoid detection insofar as MF Global did not disclose or report such transfers to the CFTC or CME until early morning on Monday, October 31, 2011.”

Read the rest at Forbes.com, MF Global Assets Have Left The Building: How, When, Where.

Other stories of mine about this issue include:

At Forbes:

October 31, 2011 MF Global : 99 Problems And Auditor PwC Warned About None

At American Banker:

Auditor PwC Should Have Been on Top of MF Global
November 4, 2011 If MF Global commingled client funds, it would be PwC’s fault as much as Jon Corzine’s.

Are Cozy Ties Muzzling S&P on MF Global Downgrade?
October 28, 2011 Jon Corzine’s old ways got his firm into trouble. Now he’s hoping old ties will bail it out.

Main page image, “Elvis has left the building” by Simon Crubellier.