Thursday, 23 December 2010

Finally Auditors Brought To Account

Until this week auditors had largely side-stepped blame for the financial crisis. This week civil-fraud charges were brought against Ernst & Young for its role in the collapse of Lehman Brothers.

Auditors passed judgment on some of the practices that caused the big losses that led to government bailouts. The case against Ernst highlights the roles accounting firms played and raises questions about whether reforms enacted after the last financial crisis have gone far enough.

Auditing isn't meant to stop companies from making dumb business moves' just to make sure those moves are properly disclosed.

Accounting firms were at the center of the last financial crisis, when companies such as Enron Corp. and WorldCom Inc. collapsed amid scandals in 2001. New accounting rules focused on the abuses of the time, but touched on some of the issues in the Ernst case.

PricewaterhouseCoopers is the auditor for American International Group and Goldman Sachs Group. KPMG LLP audits Citigroup. Deloitte & Touche LLP was the auditor for Bear Stearns and audits Fannie Mae.

Several investigations are currently underway into some of these companies and their auditors, though none are expected to yield charges in the immediate future.

"We have to take this as a very serious red flag that there really may be something that has changed in the audit industry," said Lynn Stout, a professor of corporate and securities law at the University of California, Los Angeles.

That's particularly the case with the valuation methods for companies' assets, she said. "Companies rely on auditors to bless their valuation methods and there's so much subjectivity," Ms. Stout said. "There's a real problem if we can't rely on the valuations."

Michael J. Gallagher, head of PricewaterhouseCoopers' U.S.A. national office, said, "This was fundamentally an economic crisis, but all parties in the financial reporting chain should use the lessons learned to continue improving financial reporting going forward to better serve investors and the capital markets."

A spokesman for KPMG declined to comment. A spokesman for Deloitte couldn't be reached for comment.

The Wall Street Journal sees parallels in the role played by the credit-ratings firms in the current crisis and the one played by the auditors. 'In both cases, the firms are paid by the companies they are supposed to evaluate independently. "When the people being watched get to choose their watchdog, they're not going to choose the toughest animal around". Lehman paid Ernst $185 million in fees in the decade before the investment bank collapsed.

1 comment:

Jonathan Bryce said...

I think this one will be a bit more difficult than the likes of Enron or Worldcom. There, the companies had assets shown in their balance sheets which simply didn't exist, and the auditors should have spotted that.

In the case of Lehman Brothers and AIG the assets did exist - eg loans to customers of Southern Pacific Mortgages (Leham Bros) and Ocean Finance (AIG), but they turned out to be worth less than what people thought they were worth.

The auditors would be following these rules
http://web.ifac.org/download/a035-2010-iaasb-handbook-isa-620.pdf to check that the valuations have been calcluated in accordance with these rules
http://www.iasb.org/NR/rdonlyres/1D9CBD62-F0A8-4401-A90D-483C63800CAA/0/IAS39.pdf and disclosed in the accounts in accordance with these rules
http://www.iasb.org/NR/rdonlyres/0242B440-1174-4BED-B399-B5BA248D0D06/0/IAS32.pdf
(none of this is recommended christmas bed-time reading).

At the time the accounts were published, I'm pretty sure these toxic loans were being bought and sold for the amounts shown on the balance sheet. The fact that people were paying silly money for something that isn't worth anything isn't something the current rules cater for, and I'm not sure how they can easily be changed so that they can.