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How Well Do You Perlustrate?

October 23, 2013 | About:
David Chulak

David Chulak

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Perhaps this should be asked along with the question of how well the equity you have recently purchased or are considering purchasing has been perlustrated by the auditor of record. "Perlustrate" comes from the Latin perlustratus, meaning to wander through or examine. More specifically, it means to place under a microscope or to scrutinize a thing: to dissect, examine thoroughly, contemplate, pierce and probe. This should be what is referred to as “SOP” or standard operating procedure for investors, but just how well is the auditor, that is signing off on the SEC forms that each company is required to file regularly, doing in regard to the required audit or examination? After all, these are the filings that investors like you may read in an effort to find the very best of stocks.

Based upon the book by Thornton L. O’Glove, "Quality of Earnings," they have not performed well. O’Glove, along with his then partner Robert Olstein of Olstein Capital Management, formed the Quality of Earnings Reports which offers institutions and professional investors forensic studies of equities under consideration.

Thornton’s book starts with the first three chapters disparagingly talking about those that cannot be trusted in the endeavor of investment advice. It somewhat reminds those of us old enough to remember the chant or slogan of the 1960s not to trust anyone over 30. The first chapter is aptly named, “Don’t Trust Your Analyst.” O’Glove doesn’t sugar coat it with a friendly title. The second chapter, “Don’t Trust Your Auditor,” is equally brutal, and the third is a slightly less judgmental look at CEOs and their letters to the shareholders.

It is pointed out that there are four (4) categories that auditors may assign their audit. One is that of being “clean” or of unqualified acceptance. The others may be issued with words of warning such as, “except” or “with exception, “subject to” or even a disclaimer of opinion. Most often, investors, if they glance at the three or four paragraph or statement by the auditor see the unqualified statement and assume that all is well. The auditor has done their job and reviewed the statements sufficiently to issue a “clean” verdict. The stock has been given the stamp of approval by an auditor; therefore, all is well and it must be clear to purchase.

Not so fast, declares O’Glove. He goes on to give a few anecdotal stories such as the reports issued for Baldwin-United, Penn Square Bank and Continental Illinois. It is noted that all were issued “clean” reports just prior to their failure. Similar to the stock analyst, the auditor, though required to remain independent and being paid millions of dollars to issue their opinion, wants to retain their business with the company and hopes they are able to issue, indeed, has incentive to issue, a “clean” report. That is why most investors look upon the analyst reports and auditor statements with skepticism.

How prevalent is this problem? Apparently, a lot more than many or most suspect. In August of 2012, the New York Times ran an article entitled, “Bad Grades Are Rising for Auditors.” The title of the article alone flags where this exposition is headed. Citing a report by the Public Company Oversight Board, the report discusses audits in general and the “big four” specifically in regards to the quandary of issuing a “clean” report. The article reports that the review by the board of the big four, consisting of KPMG, Ernst & Young, PricewaterhouseCoopers and Deloitte & Touche discovered an error or problem in one is six audits, while a year later, the score was reduced to one in three. Smaller companies actually reported worse results. Lynn E. Turner, former chief accountant for the SEC was quoted:

“If any other business, such as manufacturing or software companies, had such high failure rates in their products, they would go out of business.”

Reminiscent of the housing bubble and crash debacle, the leader of the Financial Accounting Standards Board, Robert H. Herz, was strongly criticized by congressional members for his reports on banks and shortly thereafter was able to persuade the chief to loosen the rules.

One may ask, “But what about the audit committees?” Audit committees, composed of approximately six board members with obligatory financial experience, are required for all public companies and directed to provide oversight for proper reporting, oversight of internal controls and oversight of the auditor contracted to perform said audit of the firm, among a variety of other duties. Duties of the committee were increased with the inauguration of the Sarbanes-Oxley Act of 2002.

In the words of Warren Buffett, “Audit committees can’t audit.” Buffett himself sits on these committees, along with his long-time partner Charlie Munger who was reported to fall asleep during these committee meetings. Buffett discusses audit committees in “The Essays of Warren Buffet: Lessons for Corporate America,” stating that the main goal of the members is to get the auditor to disclose what has been unearthed, if anything. Buffett emphasizes that the auditor views management as their client rather than objectively approaching the job at hand and leaving the outcome to their findings.

While I am unable to find reference disclosing that Buffett follows his own advice, he states that audit committees would best be served by addressing four questions directly to the auditor that would maintain the independence of the auditor from management and allow the committee to respond to the auditor on issues raised.

· “If the auditor was solely responsible for preparation of the company’s financial statements, would they have in any way been prepared differently from the manner selected by management?”

· “If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?”

· “Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO?”

· “Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another?”

Buffett concludes that when auditors are placed in difficult positions by being asked such questions, they will perform as required. Aside from saving a great deal of time and money, Buffett asserts that once the auditor has been required to answer positively to each of these questions, any desire to comply or submit to managements desire for a clean report will be resisted or refused.

The Public Company Accounting Oversight Board publishes its findings when reviewing the audits of these firms. The report for PricewaterhouseCooper LLP, dated Nov. 8, 2011, lists no less than 24 deficiencies which included such descriptions as, “failure to assess properly” (various components), “failure to obtain proper corroboration,” “failed to sufficiently test,” “failure to assess revenue,” failed to test account receivables, etc.

Is there any value to reading the auditor’s statement at the end of the SEC filing? I am reminded of the story Buffett tells about sitting around playing poker and if that after 30 minutes you don’t know who the patsy is, it’s you. Since one in six or one in three audits of the big four have errors, there is little to gain by reading them. The best I can suggest is that you read it and:

1. If you see that the reports are “clean,” treat that skeptically or with a grain of salt and continue to do your own homework before making a decision.

2. If the report includes what I referred to as the “words of warning” such as “except” or “subject to,” etc., note the flag. This should be taken seriously. One is better researching the issues themselves and determine whether they wish to continue research on the stock in question.

3. Assess the experience of the auditor. Note that Bernie Madoff used an unknown auditor. This, in itself, does not make for fraud or make for an inefficient or inaccurate report, but you should determine or question the experience of the auditor, along with their independence.

4. Assess the required financial experience of the audit committee. Do the members have the experience required to determine a fair and complete report?

Don’t trust the auditor. Don’t trust the audit committee. Don’t trust the analyst.

Disclosure: No positions.

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

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