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Accounting Board to Seek Comments on Rotating Auditors

August 17, 2011 by Leave a Comment

The regulatory body, the Public Company Accounting Oversight Board, voted unanimously to seek comment over the next four months on a concept known as mandatory audit firm rotation. The practice would limit the number of consecutive years that an accounting firm could audit the books of a publicly traded company.

The proposal is the third significant measure that the accounting board, created in 2002 as part of the Sarbanes-Oxley Act, has begun to examine in an effort to give investors greater certainty that auditors are in fact doing their job — something that was not always clear after the 2008 financial crisis, the Enron collapse and other recent accounting failures.

“The reason to consider auditor term limits is that they may reduce the pressure auditors face to develop and protect long-term client relationships to the detriment of investors and our capital markets,” said James R. Doty, the chairman of accounting oversight board and an advocate of the idea.

In part, he said, those pressures exist because of “the fundamental conflict of the audit client paying the auditor,” which could create incentives for the auditor to render a favorable, yet misleading, opinion.

Some other members of the five-person board voiced doubts about the concept, however, saying that the cost of getting new auditors up to speed on large companies every few years would burden both the company being audited and the accounting firms.

“I have serious doubts that mandatory rotation is a practical or cost-effective way of strengthening independence,” said Daniel L. Goelzer, who is one of the board’s two certified public accountants. While he recognizes the potential for auditor bias in favor of a client, Mr. Goelzer said, “there are already powerful forces built into public company auditing to foster and maintain independence.”

The board has asked for comments on how to improve auditor independence to be submitted by Dec. 14. It also plans a public meeting to discuss the proposal in March. Any rule approved by the board also has to be approved by the Securities and Exchange Commission to take effect.

Mandatory audit firm rotation has been considered at various times since the 1970s. Most recently, in 2002, Congress considered including it in the Sarbanes-Oxley legislation, but decided instead to require a report on the topic by the General Accounting Office (now called the Government Accountability Office). The act did require auditors to rotate the partner in charge of a company’s audit every five years.

The G.A.O. report, issued in 2003, found that “mandatory audit firm rotation may not be the most efficient way to enhance auditor independence and audit quality.” Firms also estimated that first-year auditing costs would rise by 20 percent as a new auditor got up to speed on a company.

But the report also said that the board would need to consider the results of its reviews of audits and auditing firms to determine whether more needed to be done, particularly in cases where a company had used the same auditor for decades.

Steven B. Harris, a member of the accounting oversight board, said the evidence showed that the Sarbanes-Oxley measures had failed to eliminate “the strong incentives that lead some auditors to serve the interests of the company paying the bills rather than those of investors.”

Eight years of those reviews have revealed “several hundred cases” where “the firm failed to fulfill its fundamental responsibility in the audit — to obtain reasonable assurance about whether the financial statements are free of material misstatement,” according to the board’s release.

In the most recent reporting cycle, ended last year, the board’s inspectors “have also identified more issues than in prior years.”

The board is seeking comments on whether mandatory audit rotation would enhance objectivity among auditors and make them better able to resist management pressure, and if so, what would be an appropriate term length.

Also of interest to the board is whether it might require rotation only for a subset of publicly traded companies, like the largest companies; whether there are enough qualified auditors to permit giant multinational companies to change regularly; and whether the practice would lead to opinion shopping.

Considering mandatory audit rotation is one of three changes in auditing practice that the board is considering. The other proposals also are still in the early stages. One of those, which has already finished its comment period, would require accounting firms to have the partner in charge of an audit sign the firm’s report, much as a company’s executives have to attest to its financial statements.

Another, on which comments are due Sept. 30, would expand the scope of the auditor’s report, which now is little more than a boilerplate statement that the financial information fairly reflects the company’s economic condition.

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High & Low Finance: Lehman Case Hints at Need to Stiffen Audit Rules

July 29, 2011 by Leave a Comment

That, anyway, is the conclusion a federal judge has reached regarding Lehman Brothers. The judge said this week that it appeared Lehman had violated Generally Accepted Accounting Principles, or GAAP, even if it was in technical compliance with accounting rules. But he threw out a claim against Ernst Young, whose 2007 audit certified that Lehman had followed GAAP.

The ruling ought to raise a few eyebrows at the Public Company Accounting Oversight Board, which sets auditing standards and regulates auditing firms. If the Lehman audit was in compliance with the auditing rules, it is time to review the rules.

A little history: As the financial position of Lehman Brothers grew more and more perilous in 2007 and 2008, the company assured investors it was reducing its leverage by selling assets. That was, to put it ever so gently, a lie.

Without that lie, Lehman probably would have failed anyway. But regulators and investors might have seen the disaster coming a little earlier.

As always happens when a company collapses, class-action suits were filed by suffering investors. They sued Lehman’s executives and its outside directors. They sued Ernst. They sued all the investment banks — 51 of them — that underwrote securities issued by Lehman.

As always happens, the defendants tried to get the suit thrown out before any evidence could be collected.

This week the judge, Lewis A. Kaplan, refused to dismiss most of the suit. But Ernst came close to getting off entirely. The judge ruled that although there was evidence that Ernst should have done something differently in the final weeks of Lehman’s existence, there would be no trial on whether the firm’s audit of the 2007 financial statements was bad.

Lehman managed to hide as much as $50 billion of borrowing — and reduce its assets by the same amount — through something that has become immortalized as “Repo 105” transactions. Those transactions, completely hidden from investors while Lehman was heading to disaster, were disclosed last year in a blistering report by Lehman’s bankruptcy trustee. The fiddling did not affect profits, but it did make the company appear to be taking fewer risks than it was.

Judge Kaplan’s decision, it should be noted, was on a motion to dismiss and was not a finding that anyone had acted wrongly. In reaching his decision, he was required to assume that facts in the complaint were accurate and could be proven.

But the current state of class-action litigation makes the dismissal ruling very important. The law lets companies essentially tell the judge that “the plaintiff has no evidence we misbehaved, so you have to throw the case out before discovery lets the plaintiff find out if there is any evidence.” It is not unusual for a suit to be settled once a judge lets a case proceed.

At the heart of the Lehman case are repurchase agreements, commonly called repos, which are a common form of financing on Wall Street. The borrower “sells” securities for cash and agrees to repurchase them at a set price in a brief period.

Normally, repos are accounted for as borrowings, which is what they are. The borrower retains all the upside and downside of the securities in question. The lender gets an interest rate.

But Lehman found a loophole in an accounting rule, and concluded that if it put up $105 in collateral for every $100 borrowed, it could claim it really was a sale. At the end of each quarter, the company would decide just how much it needed to beautify its balance sheet, and would do repos to produce the desired result. They would be reversed a few days later.

The judge concluded that Lehman did not violate the accounting rule.

But, he added, “the fact that Lehman’s accounting for the Repo 105 transactions technically complied” with the rule “does not mean that Lehman’s financial statements complied with GAAP.”

Although companies hate it, that is the law. The United States Court of Appeals for the Second Circuit, in refusing to throw out the conviction of Bernie Ebbers, the former chief executive of WorldCom, said in 2006 that “GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.”

In the Lehman case, Judge Kaplan focused on the lack of evidence that Ernst had noticed what was going on.

Floyd Norris comments on finance and the economy at nytimes.com/norris.

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Indian Accounting Firm Is Fined $7.5 Million Over Fraud at Satyam

April 6, 2011 by Leave a Comment

The S.E.C. and the Public Company Accounting Oversight Board fined the affiliate, PW India, $7.5 million in what was described as the largest American penalty ever against a foreign accounting firm.

The Satyam fraud, which was exposed in early 2009 when the company’s chairman admitted it, stunned India and American investors who had relied upon the company’s statements. The company’s securities traded on the New York Stock Exchange, as well as in Indian markets. Former Satyam officials, as well as two partners in PW India, face criminal charges in a trial under way in India.

The S.E.C. said the auditors had failed to independently confirm cash balances in bank accounts that supposedly rose to over $1 billion by the time the fraud ended. Had the balances been real, they would have accounted for more than half the company’s assets. The company later said that its actual cash balances at the end of September 2008 were $66 million, not the more than $1 billion it claimed.

The auditors, legally part of five separate firms that, together with five others, do business as PW India, did not seek confirmation of cash balances from the banks involved, but instead relied on management to provide them, the S.E.C. said, adding that that was a violation of auditing standards.

“The failures in the confirmation process on the Satyam audit were not limited to that engagement,” the S.E.C. stated in a cease-and-desist order issued against the firm, “but were indicative of a quality control failure throughout PW India.” The commission added that audit “engagement teams throughout PW India routinely relinquished control of the delivery and receipt of cash confirmations to their audit clients and rarely, if ever, questioned the integrity of the confirmation responses they received from the clients.”

In some cases, banks sent confirmations to the audit firm directly — despite not being asked to do so — and those statements differed markedly from the ones the management provided. BNP Paribas advised the auditors that Satyam had a cash balance on March 31, 2007, of $11.2 million, while the company claimed $108.6 million. A year later, Citibank reported $330,172 in its Satyam account, only 2 percent of the $152.9 million Satyam claimed. The audit firm did not follow up on the discrepancies.

“PW India violated its most fundamental duty as a public watchdog by failing to comply with some of the most elementary auditing standards and procedures in conducting the Satyam audits,” said Robert Khuzami, the commission’s director of enforcement.

Although audit firms around the world use similar names and are part of global networks, the firms say they are legally independent. The international networks say they have procedures to assure that their affiliates perform high-quality audits, but those procedures appear to have broken down in this case.

Those procedures include having partners from different firms in the network review audits. While the 2008 audit was being conducted, the S.E.C. said, a partner from a different PwC firm “alerted members of the Satyam engagement team that its cash confirmation procedures appeared substantially deficient,” but the Indian firm did nothing to correct the procedures.

Had the firm done as the foreign partner advised was proper, the commission said, “Satyam’s fraud could have been uncovered in the summer of 2008.”

Satyam is now under new management and continues in business. It agreed to pay a $10 million fine to settle a related S.E.C. case regarding the fraud.

The Public Company Accounting Oversight Board, which licenses and inspects audit firms, was established by the Sarbanes-Oxley Act in 2002 after the Enron and WorldCom scandals. It fined PW India $1.5 million, in addition to the $6 million penalty levied by the S.E.C.

In a statement, PW India said that it had neither admitted nor denied wrongdoing and emphasized that neither of the American regulators “found that PW India or any of its professionals engaged in any intentional wrongdoing or was otherwise involved in the fraud perpetrated by Satyam management.”

The accounting board barred two PW India accountants from taking part in audits of American companies but said it did so because they had refused to cooperate with its investigation.

An official in PwC’s global network, Donald A. McGovern Jr., said that after the Satyam fraud was revealed, the PwC network took steps “to verify that professional standards relating to confirmations were being met” throughout the network. Mr. McGovern, whose title is global assurance leader, said the firm also “instituted an enhanced assurance quality review process for all network firms.”

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