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Ineffective Auditors Might End Up Buried Along With Dying Banks

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By JONATHAN WEIL

Bloomberg News

Published: January 17, 2009

Here's hoping the big audit firms get busy living and start sounding alarms at banks that are dying.

Credit raters, regulators, Wall Street executives, even hedge-fund managers all got summoned to Capitol Hill in the fall for televised floggings. Yet barely a glove has landed on the Big Four accounting firms.

One after another, huge financial institutions collapsed in 2008 under fantasyland balance sheets while their accounting firms couldn't manage to find anything wrong. Ernst & Young LLP was auditor for Lehman Brothers Holdings Inc. and IndyMac Bancorp Inc. KPMG LLP audited Wachovia Corp. Deloitte & Touche LLP had Washington Mutual Inc. and Fannie Mae.

PricewaterhouseCoopers LLP somehow missed that Freddie Mac's books were a joke. PwC also audited American International Group Inc. At least there the firm had the good sense to tell us AIG's accounting controls were weak. (Talk about an understatement.)

The public's patience may be running out. One sure sign is that investors are starting to blame big accounting firms for fraud at places they never even audited. Theres been no indication that PwC or KPMG, for instance, should have known Bernard Madoff was running a Ponzi scheme when they blessed the books of other funds that sent him money. The firms are getting impugned anyway, even though Madoff's auditor was someone else.

Fraud By The Numbers?

Then there are the scandals where the firms have lots of explaining to do. Last week, PwC's India affiliate issued a statement about its work for Satyam Computer Services Ltd., which overstated its cash by $1 billion. The firm said its audits were conducted in accordance with applicable auditing standards and were supported by appropriate audit evidence.

The statement came only a day after Satyam's chairman disclosed the fraud. How could that have been enough time to conduct a thorough investigation? Beats me. Whatever facts the firm relied on to verify Satyam's cash, it's hard to see how they could have been the appropriate ones.

Undoubtedly there will be pressure the next several weeks - if not express pleas by banking regulators - for auditors to let lots of phony asset values slide. Some might try to rationalize that a little fraud is OK if done in the name of saving the financial system. After all, those squishy numbers require judgment. Why not press the scales the way management wants?

A public accounting firm's real client, however, isn't the company that pays its fees. It's the public - the individuals who rely on companies' financial reports to make decisions about how to allocate capital.

Curiously, this is the same business model that earned Moody's Corp. and the other credit-rating companies so much criticism. There has been no commensurate outrage lately over the same conflict of interest at auditing firms: getting paid by the companies they grade.

KPMG, for one, is fortunate to be alive. On June 13, 2005, its new chairman, Timothy Flynn, was in a packed Justice Department conference room in Washington, begging the deputy attorney general not to bring criminal charges against his firm for selling illegal tax shelters.

Flynn promised that KPMG would go back to the core business of auditing corporations and focus on being an audit watchdog, according to a KPMG attorney's notes of the meeting filed with a federal court in New York. KPMG paid $456 million to settle and avoided prosecution. Almost four years later, were still waiting for the auditor watchdogs to bark at Citigroup Inc.

No More Fuzzy Math?

For investors, the year-end financial statements that companies are preparing now will include some of the most important numbers ever reported. And for the major accounting firms, the numbers will matter like never before.

Annual financial statements at U.S. public companies must be audited by independent accounting firms, and the firms must attest to those reports in writing. Quarterly results merely have to be reviewed by auditors; no written reports are required. A firm that gets caught letting a big company fudge its audited results could face crippling legal liability.

If Citigroup issues yet another balance sheet that defies belief, it will be KPMG's neck on the line. Likewise, PwC will be betting the future on its ability to keep Bank of America Corp's books clean. Deloitte has Morgan Stanley to worry about. Ernst's headaches include Regions Financial Corp.

One thing those banks have in common is that the investing public doesn't believe the numbers, judging by the huge discounts to book value at which their stocks trade. That's a rebuke of their management and boards. It also shows that investors don't think much of the outside auditors.

Theres no law that says accountants must approve financial statements that make them uncomfortable. They have the power and freedom to resign from any audit at any time. And no company is worth dying for, no matter how big the fees. (Just ask Arthur Andersen LLP.) The auditors have all the leverage they need.

This may be their last and best chance to get it right.

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