Contributing editor Tom Slee is here this week with some insightful, and disturbing, comments on the role played by auditors in the financial meltdown and what it means for investors. Tom trained as an accountant so he writes from the perspective of someone who has hands-on experience in this field. Here is his report.
Tom Slee writes:
Now that we have had time to analyze the financial crisis and the post-mortems are over, one big question remains. Where were the auditors? These highly-paid watch dogs were supposed to be our first line of defense. Fat chance! They continued to reassure shareholders and investors even while we were going over the cliff. Bear Sterns, Carlyle Capital, Thornburg Mortgage, and Lehman Brothers all hit the buffers shortly after receiving clean bills of health. It's very discouraging, especially for small investors who have to accept financial statements at face value. It's also puzzling that the auditing profession has not been held to account, although that may be changing.
Just before Christmas, New York's then Attorney-General, Andrew Cuomo, charged auditors Ernst & Young with fraud in connection with the Lehman Brothers collapse. He alleged that the firm helped disguise the bank's financial condition for seven years while pocketing more than US$150 million in fees. In response, Ernst & Young stated that the charges have "no factual or legal basis". Then the auditing firm delivered a bombshell. It went on to say that Lehman's statements were fine, they conformed to accounting standards. I find that astonishing.
The truth is that in the summer of 2008, Lehman's statements were a house of cards. On March 17, the bank reported first quarter earnings of $489 million or $0.81 a share (figures in U.S. currency), easily beating expectations. The numbers were surprisingly good and CFO Erin Callan took advantage of them to issue a glowing forecast. A lot of investors bought the stock.
But not everybody was convinced. Wall Street analysts, with far less access to the accounts than the auditors who had reviewed Ms. Callan's release, immediately challenged the results. Then the unraveling began and a few months later Lehman filed for creditor protection. It was the largest bankruptcy in U.S. history.
Now I am not for a moment suggesting that Ernst & Young did anything wrong. They may have applied all the required tests and reassured themselves that the figures were presented according to generally accepted accounting principles (GAAP). My point is that the audit managers seemed to be unconcerned in which case what was the use of employing them? I am no great fan of Wall Street analysts but at least they realized the results were suspect just by looking at them.
It's not as though the Lehman case was an exception. Investigations into the financial disaster show that many of the U.S. merchant banks blatantly misrepresented their financial positions. Merrill Lynch successfully hid $31 billion worth of toxic assets by selling them to a specially created vehicle while remaining on the hook for any losses. Shareholders were at risk, yet the auditors approved the statements.
There was slipshod work elsewhere during the crisis. A recent report by the Public Company Oversight Board listed an array of cases where auditors failed to comply with accepted standards during the 2007-2009 period. The report states that, amongst other deficiencies, auditors failed to challenge or verify company valuation models. In other words, they took management's word for the numbers and the process.
So why have we not heard a lot more about the auditors' role in the great crash? Mortgage lenders, real estate speculators, bankers, corporate executives, regulators, and ratings agencies have all been raked over the coals in public. Very little, however, has been said about the major accounting firms. Why? Perhaps Jim Peterson, a noted U.S. financial commentator, had the answer after a hedge fund management meeting when he said: "Where were the auditors in this crisis? Nobody asks, because nobody cares". It's true, at least to some extent. Accountants have been unbidden and unheard in the public debates about blame and solutions for the market debacle.
I think that one of the main reasons public auditors have been marginalized is because they are no longer regarded as independent professionals. Certainly most institutional investors see them as an extension of management, fiercely loyal to their employers, the boards of directors. That may be unfair but it's certainly the perception, reinforced by the fact that many major corporations are becoming closely related to their auditing firms. It's now almost standard practice for a company's CFO and most of its internal audit staff to have graduated from the firm now passing judgment on their work. In many cases the auditors also provide the company with consulting services.
Moreover, auditors have lost a lot of credibility by hedging their opinions and making sure that management is solely responsible for the numbers. As a result, institutional fund managers know that they have no legal recourse against auditors even when the accounts are suspect or contentious.
Perhaps most important, auditors are no longer equipped to pass judgment on a great many aspects of financial statements. This is no reflection on their ability. It's just that times have changed. Conventional accounting became unhinged during the dot-com boom when people were required to assess the value of esoteric intangibles such as intellectual property. A little later, mark-to-market and the advent of derivatives gave us a whole new ball game. As a result, there is now a great deal of opinion and it's extremely difficult to run independent cross checks. For instance, the Accounting Oversight Board has criticized auditors for applying the same flawed Moody's or Standard & Poor's models that companies used to value their subprime derivatives. Yet it's difficult to see what else they could have done short of developing their own costly valuations.
I could go on. For example, how do you value assets without any true market such as the corporation's head office and how often should you do so? When Bear Sterns ran into difficulties in 2008, its executives admitted that they were unable to understand their trading department's convoluted asset-backed deals. So how could the auditors possibly verify those results? No wonder the major auditing firms are adjusting their business mix. The four major firms now derive one-third of their income from consulting, a growth area while auditing revenues remain stagnant.
Where does this leave small investors? Well, I think that we have lost another safeguard. So, from now on I would be even more inclined to favour large-cap stocks with their widespread analyst coverage. Tread carefully when you are adding small-cap or unlisted issues to your portfolio. They have little or no on-going scrutiny. Nobody is going to hold management's feet to the fire. You have to depend on the company's numbers that these days are bound to involve a lot of judgment.
My suggestion for investors needing a second line of defense, especially when dealing with financial stocks, is to look for companies with little institutional ownership and a substantial number of independent directors. The American Accounting Association's recent survey of how 296 major financial institutions performed during the market collapse found that this was the best management/ownership mix. The findings showed that insider directors were naturally inclined to hide bad news but independent board members with smaller stakes demanded more transparency and this gave companies time to take defensive measures. When institutions became involved, corporations were more prone to take risks and suffer as a result.
Tom Slee writes:
Now that we have had time to analyze the financial crisis and the post-mortems are over, one big question remains. Where were the auditors? These highly-paid watch dogs were supposed to be our first line of defense. Fat chance! They continued to reassure shareholders and investors even while we were going over the cliff. Bear Sterns, Carlyle Capital, Thornburg Mortgage, and Lehman Brothers all hit the buffers shortly after receiving clean bills of health. It's very discouraging, especially for small investors who have to accept financial statements at face value. It's also puzzling that the auditing profession has not been held to account, although that may be changing.
Just before Christmas, New York's then Attorney-General, Andrew Cuomo, charged auditors Ernst & Young with fraud in connection with the Lehman Brothers collapse. He alleged that the firm helped disguise the bank's financial condition for seven years while pocketing more than US$150 million in fees. In response, Ernst & Young stated that the charges have "no factual or legal basis". Then the auditing firm delivered a bombshell. It went on to say that Lehman's statements were fine, they conformed to accounting standards. I find that astonishing.
The truth is that in the summer of 2008, Lehman's statements were a house of cards. On March 17, the bank reported first quarter earnings of $489 million or $0.81 a share (figures in U.S. currency), easily beating expectations. The numbers were surprisingly good and CFO Erin Callan took advantage of them to issue a glowing forecast. A lot of investors bought the stock.
But not everybody was convinced. Wall Street analysts, with far less access to the accounts than the auditors who had reviewed Ms. Callan's release, immediately challenged the results. Then the unraveling began and a few months later Lehman filed for creditor protection. It was the largest bankruptcy in U.S. history.
Now I am not for a moment suggesting that Ernst & Young did anything wrong. They may have applied all the required tests and reassured themselves that the figures were presented according to generally accepted accounting principles (GAAP). My point is that the audit managers seemed to be unconcerned in which case what was the use of employing them? I am no great fan of Wall Street analysts but at least they realized the results were suspect just by looking at them.
It's not as though the Lehman case was an exception. Investigations into the financial disaster show that many of the U.S. merchant banks blatantly misrepresented their financial positions. Merrill Lynch successfully hid $31 billion worth of toxic assets by selling them to a specially created vehicle while remaining on the hook for any losses. Shareholders were at risk, yet the auditors approved the statements.
There was slipshod work elsewhere during the crisis. A recent report by the Public Company Oversight Board listed an array of cases where auditors failed to comply with accepted standards during the 2007-2009 period. The report states that, amongst other deficiencies, auditors failed to challenge or verify company valuation models. In other words, they took management's word for the numbers and the process.
So why have we not heard a lot more about the auditors' role in the great crash? Mortgage lenders, real estate speculators, bankers, corporate executives, regulators, and ratings agencies have all been raked over the coals in public. Very little, however, has been said about the major accounting firms. Why? Perhaps Jim Peterson, a noted U.S. financial commentator, had the answer after a hedge fund management meeting when he said: "Where were the auditors in this crisis? Nobody asks, because nobody cares". It's true, at least to some extent. Accountants have been unbidden and unheard in the public debates about blame and solutions for the market debacle.
I think that one of the main reasons public auditors have been marginalized is because they are no longer regarded as independent professionals. Certainly most institutional investors see them as an extension of management, fiercely loyal to their employers, the boards of directors. That may be unfair but it's certainly the perception, reinforced by the fact that many major corporations are becoming closely related to their auditing firms. It's now almost standard practice for a company's CFO and most of its internal audit staff to have graduated from the firm now passing judgment on their work. In many cases the auditors also provide the company with consulting services.
Moreover, auditors have lost a lot of credibility by hedging their opinions and making sure that management is solely responsible for the numbers. As a result, institutional fund managers know that they have no legal recourse against auditors even when the accounts are suspect or contentious.
Perhaps most important, auditors are no longer equipped to pass judgment on a great many aspects of financial statements. This is no reflection on their ability. It's just that times have changed. Conventional accounting became unhinged during the dot-com boom when people were required to assess the value of esoteric intangibles such as intellectual property. A little later, mark-to-market and the advent of derivatives gave us a whole new ball game. As a result, there is now a great deal of opinion and it's extremely difficult to run independent cross checks. For instance, the Accounting Oversight Board has criticized auditors for applying the same flawed Moody's or Standard & Poor's models that companies used to value their subprime derivatives. Yet it's difficult to see what else they could have done short of developing their own costly valuations.
I could go on. For example, how do you value assets without any true market such as the corporation's head office and how often should you do so? When Bear Sterns ran into difficulties in 2008, its executives admitted that they were unable to understand their trading department's convoluted asset-backed deals. So how could the auditors possibly verify those results? No wonder the major auditing firms are adjusting their business mix. The four major firms now derive one-third of their income from consulting, a growth area while auditing revenues remain stagnant.
Where does this leave small investors? Well, I think that we have lost another safeguard. So, from now on I would be even more inclined to favour large-cap stocks with their widespread analyst coverage. Tread carefully when you are adding small-cap or unlisted issues to your portfolio. They have little or no on-going scrutiny. Nobody is going to hold management's feet to the fire. You have to depend on the company's numbers that these days are bound to involve a lot of judgment.
My suggestion for investors needing a second line of defense, especially when dealing with financial stocks, is to look for companies with little institutional ownership and a substantial number of independent directors. The American Accounting Association's recent survey of how 296 major financial institutions performed during the market collapse found that this was the best management/ownership mix. The findings showed that insider directors were naturally inclined to hide bad news but independent board members with smaller stakes demanded more transparency and this gave companies time to take defensive measures. When institutions became involved, corporations were more prone to take risks and suffer as a result.
