Bloomberg’s Jonathan Weil Is On A Roll

Five months later, on Aug. 6, American Home filed for Chapter 11 bankruptcy-court protection, still brandishing the firm’s clean audit-opinion letter.

There’s a reason why you don’t see auditors pursuing second careers as tarot-card readers. They wouldn’t be very good at it. Yet every time an accounting firm renders an opinion on a client’s financial statements, the auditing standards say it must evaluate the company’s ability to continue as a going concern, and warn the public if it concludes there’s “substantial” doubt, a term the rules don’t define.

The home-mortgage industry’s growing casualty list is a reminder: They’re not very good at that either.

You almost have to feel sorry for the Deloitte accountants who drew this thankless task. While in hindsight it looks like they made a bad call, they also were in a pickle.

Dreaded Language

Tucked inside American Home’s credit-facility agreement was a clause that said the Melville, New York-based company would be in default with lenders if its auditor tagged it with the dreaded going-concern language.

For the accountants, if they thought for even a second about this, it must have felt like staring into a house of mirrors. Had they made what proved to be the right call, they probably would have inflicted a mortal wound on American Home. Then again, looking back, a self-fulfilling prophecy would have spared investors from the company’s April 30 public offering of 4 million shares at $23.75 each, the prospectus for which incorporated Deloitte’s audit opinion. American Home’s shares closed yesterday at 22 cents.

The auditing standards stress that auditors are “not responsible for predicting future conditions or events,” and that a company’s sudden failure without any going-concern warning “does not, in itself, indicate inadequate performance by the auditor.”

Auditors’ Judgments

Even so, financial statements depend heavily on auditors’ judgments about a company’s forecasts. Look at almost any balance sheet, and the asset and liability values hinge on the company’s ability to remain in business. Those numbers would look far different if the company were preparing for liquidation, with holdings listed at fire-sale prices.

That’s why going-concern evaluations by outside auditors are a necessity. Auditors may not be particularly skilled at making them. When they do bark, though, you can bet shareholders will skedaddle, because then it’s clear the problems lack plausible deniability.

Back in April 2002, after the dot-com bubble burst, a Bloomberg News study found that, in 54 percent of the largest 673 bankruptcies at public corporations since 1996, the outside auditors provided no going-concern warnings in their annual audit letters during the months preceding the bankruptcies. Smaller companies got bit much more frequently. The 50 largest companies that filed for bankruptcy protection received going- concern cautions only 24 percent of the time.

No Improvement

The auditors at today’s troubled mortgage companies are faring about as badly. One instance where the accountants got it right came in March, when New Century Financial Corp. disclosed that KPMG LLP planned to stick it with a going-concern clause, a month before the company filed for Chapter 11. New Century was the exception.

On Aug. 9, HomeBanc Corp., an Atlanta-based mortgage lender, filed for Chapter 11, still sporting a clean opinion from Ernst & Young LLP. Like American Home, HomeBanc, too, would have been in default on its credit facilities if it ever received a going-concern warning from its auditor. The next day, executives at Luminent Mortgage Capital Inc., a San Francisco mortgage investor audited by Deloitte, raised doubts about their company’s ability to continue as a going concern, though Deloitte still hasn’t withdrawn the clean opinion it issued in March. Deloitte and Ernst declined to comment.

Management Onus

One group of accountants is thinking of ways to keep shareholders better apprised. In Norwalk, Connecticut, the Financial Accounting Standards Board is working on a proposal that for the first time would place the burden of performing going-concern evaluations — and warning investors — squarely on companies’ management.

Currently, there is no clear requirement to that effect in generally accepted accounting principles. Auditors still would be on the hook, because the auditing standards would remain unchanged. And while executives surely would suffer from bias, and some would be bent on deceit, at least the people with the primary responsibility for making these calls would be the ones who supposedly know their companies best.

Dan Guy, a Santa Fe, New Mexico, author of several auditing textbooks, says the change is long overdue. “I don’t think any company in America, private or public, should have to look to auditing standards to find out what management’s responsibility is for disclosure and measurement in financial statements,” he says.