Peeling away financial reporting issues one layer at a time

Why Nothing Sticks to Auditors when Loans Go Bad

I read numerous news sources this week echoing the SEC's announcement that it finally has a case it thinks it can win against auditors stemming from the 2008 financial crisis. One journalist, Jon Weil of Bloomberg, takes it a step further to ask, 'What took so long'?

"It has been frustrating to look at the SEC's own highlights of the lawsuits it has filed in connection with the financial crisis — and to see that none of them had been against an auditor. Now the SEC will have one case to cite, albeit against a couple of small fries. It also should be stressed that the agency hasn't proved any of its allegations against these two accountants. Surely the SEC can find some bigger targets out there in the auditing world if it wants to. [emphasis added]

Actually, Jon, it can't.  The paucity of enforcement actions against auditors surely has not been for lack of trying. But, just as surely, auditors have not been doing much lately to protect investors and to promote economic stability. The topic of audit reform in response to the financial crisis has been everywhere in both the U.S. and Europe (except perhaps where it counts the most – at the SEC).

The SEC announcement comes coincidentally right on the heels of the FASB's proposal to make changes to loan accounting. Which adds another question to Jon's: would better loan accounting standards beget higher quality audits? But more on that later. First, let's discuss why auditors have been to financial reporting as Teflon is to frying pans – nothing sticks.

 

The Problem of Auditing what Managers See through Rose-colored Lenses

I've explained this before, but it bears repeating. Several financial elements are capable of being determined objectively (e.g., cash and contractual amounts for receivables and payables). Auditors are trained to verify these financial statement inputs by counting, reading, confirming, etc., and they generally do an outstanding job at this kind of work – for which any CPA is eminently qualified.

However, dozens of financial statement elements depend on management's subjective estimates of unknowable future events and myriad scenarios based on complex contracts that are often engineered solely to confound. The problem of audit reliability is almost entirely due to requirements for the auditor to state that management's judgments (in which they often have a direct interest) and mere representations of intent "appear reasonable." The impossibility of auditing the ineffable cuts to the heart of any bubble-induced banking crisis – past, present or future.

As Jon Weil observes, even if the SEC prevails in its modest quest to hold at least a couple of auditors accountable, the message value will be minimal. Moreover, for the reasons I've just stated, there is reason to fear that the SEC won't get its case past an administrative law judge (ALJ).

The SEC's case reads well. The auditors allegedly should have seen that internal controls were inadequate, they had reason to know that management's estimates were biased, and they ignored important information concernin the value of loan collateral. But, there are at least two sides to every story; and the SEC may have to meet a very high standard for its side to prevail.

If the auditors don't settle, then (follow me on this one) the SEC will have to convince the ALJ that the auditors acted "unreasonably" by not concluding that the numbers fed to them by management were themselves "unreasonable." Basically, the SEC has two shots, and I have feeling that neither one is a slam dunk. Under Section 4C of the Exchange Act, the SEC can show either one of the following: at least one instance of "highly unreasonable" conduct; or "repeated" instances of merely "unreasonable" conduct that together indicate "lack of competence."

I don't want to get into a lot of details here, but these particular standards are less than 20 years old; and they have not been tested in court very often. What is important to know (and the irony to appreciate) is that in an audit engagement or in a court of law, determining what is reasonable in the context of financial reporting is a quixotic venture. It may not matter that in this case, according to Jon Weil, the bank regulator – and not the auditor – caught the accounting errors; and the auditor resigned only weeks before the bank failed in 2010. As a matter of law, none of that may speak to the question put before an ALJ.

My guess is that the auditor is willing to put the SEC to its proof because they estimate that there is a good chance of prevailing. If they do, it will be helpful in defending against all sorts of civil litigation, where the real money is involved. (By the way, Section 4C which was added by Sarbanes-Oxley in 2002, does not permit the SEC to seek monetary damages from accountants. Maybe it should?)

 

The Only Way Forward

If I am right about the reasons why auditors have avoided SEC sanctions for their shoddy bank audits, then one must also conclude that the FASB's and IASB's proposals will accomplish nothing. Readers of financial statements will continue to be at the mercy of management wearing rose-colored lenses in bad times and creating rainy-day reserves in good times; and auditors will look on with impunity.

The facts are that holding management ultimately accountable for the accuracy of financial statements doesn't work anymore (if it ever did). Different auditing standards won't make the audit more reliable as a deterrent to financial manipulation, so long as management has the license to do the estimating – and to hire and fire the auditors.

Fundamental change is required, and that can't happen by simply leaving the IASB and FASB to their own devices. Beginning with the premise that investors want information from reliable sources that are independent of management, the only way forward is for reporting of loans to be based on fair values, which are produced by independent valuation experts. If that can be made to happen, then auditor involvement can be limited to things that every CPA already knows how to do:

  • Verify the inputs to fair value measure that can be objectively measured;
  • Attest to the adherence of professional standards by the independent valuation experts;
  • Verify that the independent valuation experts performed the procedures they were supposed to perform.

Auditors might make less money on audits, but there are benefits.  There are arguments to be made that some services that are now prohibited, should not be seen as threats to auditor independence. They won't be spending their profits defending against civil litigation and the SEC. 

They'll sleep better.

2 Comments

  1. Reply Andrew January 16, 2013

    I can’t see that your proposal would make any difference. The most likely source for the bodies that will do any independent valuation is the accounting profession. Who will be first to setup the valuation services, complete with shiny websites, the big four and possibly Accenture and the like. Will that really make it better? You may argue that a suitable system of checks and balances will make it work. I say that that will soon get subverted and anyway a system must be capable of being seen to work by the general public and that such a system is likely to be too complex for anyone to really understand let alone have confidence in. That’s to say it will be but a minor tweak to the status quo.
    Any amount of contracts and rules can be written but while the underlying game of banking, property and tax remains as it is today nothing much is going to change.
    Henry George – Progress and Poverty. Steve Keen- Debunking Economics. positivemoney.org (last is a UK site I think there’s a US equivalent).

  2. Reply david January 31, 2013

    well, the sub prime mortgage crisis in 2008 has nothing to do with external auditors or banks, it’s all because of the stupid laws from the government such as the notorious community enhancement act.
    The response from the banks is just their optimal choice under these laws. Government is the one to be blamed.
    Most people know about that.

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