May 27, 2024

High & Low Finance : How Secrecy Undermines Audit Reform

For the auditing industry, the financial crisis was really not that bad.

While nearly every other group involved in the financial system — banks, mortgage brokers, bond rating agencies, derivatives dealers and regulators — faced severe criticism and new legislation, auditors largely escaped unscathed.

There were, to be sure, a few discordant notes. The Lehman Brothers bankruptcy trustee blasted Ernst Young for allowing Lehman to use a dubious accounting method to hide its leverage in the months leading to its demise, and the attorney general of New York filed fraud charges against Ernst. Robert Herz, then the chairman of the Financial Accounting Standards Board, complained that auditors had allowed banks to violate the rules on off-balance sheet entities in order to hide assets and liabilities.

But the Dodd-Frank law did nothing to the auditors.

That was in sharp contrast to the previous round of scandals — the Enron and WorldCom accounting frauds that led to the enactment in 2002 of the Sarbanes-Oxley law. That law established the Public Company Accounting Oversight Board to audit the auditors. With a second set of eyes looking over their shoulders, it was hoped, auditors would do a better job.

While auditors may be doing a better job, that does not necessarily mean they are doing a good one.

This week James R. Doty, the new chairman of the P.C.A.O.B., let loose a blast at the job the profession had done — and was doing.

In a speech to the Council of Institutional Investors, Mr. Doty said the board had gone back and inspected the audits of many companies that later failed or were bailed out. “In several cases — including audits involving substantial financial institutions — P.C.A.O.B. inspection teams found audit failures that were of such significance that our inspectors concluded the firm had failed to support its opinion,” he said.

That is, it should be noted, not the same as saying the financial statements were wrong. It is possible that the audit firm did not do enough work to know if the statements were accurate but that they would have been acceptable even to a proper audit.

Moreover, as Mr. Doty noted, “Auditors were not charged with enforcing good risk management practices at financial institutions.” But they were supposed to make sure the statements reflected the conditions at the time. That appears not to have happened at Lehman Brothers, at least when it came to leverage, and it might not have happened at other banks.

What’s worse, the problems seem to be continuing.

In the wake of the financial crisis, no accounting issue has been more critical than the valuation of financial assets. In some cases, banks are now required to report the fair value — normally the market value — of securities they own. That is not easy for securities that rarely trade, and it was made all the harder by the complexity of some securities that Wall Street invented during the boom years. Banks claim, with some justification, that markets became unduly fearful at the height of the crisis, and that market values fell too low.

Investors and regulators could, if they chose, make allowances for depressed markets. But they need to be able to compare banks with one another, and to do that they need to have confidence that financial statements are comparable.

But the accounting oversight board does not think that has happened. In the board’s report of its 2009 inspection of PricewaterhouseCoopers, which concerns 2008 audits conducted at the height of the financial crisis, the board wrote that “in four audits, due to deficiencies in its testing of fair values of investment securities and/or derivatives, the firm failed to obtain sufficient competent evidential matter to support its audit opinion.”

It had similar complaints about each of the other members of the Big Four — KPMG, Ernst Young and Deloitte Touche.

Unfortunately for investors, the board has not revealed the names of any clients involved.

Nor do the auditors appear to have gotten everything right in later audits, at least in Mr. Doty’s view.

“Although the 2010 reporting cycle is not yet complete, so far P.C.A.O.B. inspectors have continued to identify significant issues related to the valuation of complex financial instruments, among other areas,” he said, adding that the “inspectors have also identified more issues than in prior years.”

In 2002, when the auditing firms had been humiliated by audit failures, their efforts to prevent any regulation failed, but they did win one crucial victory in the details of the Sarbanes-Oxley law. The oversight board must keep secret its most critical assessments of audits unless a firm fails to respond to the criticism. And the board’s disciplinary actions remain secret until they are resolved by the board and the Securities and Exchange Commission has ruled on any appeal.

It is as if the fact a man was suspected of robbing a bank had to be kept secret until after he was not only convicted but failed in his appeal.

That secrecy was justified as necessary to protect reputations that could be tarnished by charges that might later be disproved. In practice, board officials complain, it has led to stalling tactics by firms that figure they can avoid negative publicity indefinitely. The board has asked Congress to change the law, but that seems unlikely.

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