Back in November 2007, I wrote a post entitled, “Do You Believe In Santa Claus – The Auditors and The Subprime Crisis.”
All Others – 11%
I also got a call from a reporter from the FT who asked me to explain why I felt the auditors were part of the problem. This reporter stated, “…the problem is not one of internal controls or lack thereof, but of building up portfolios of illiquid assets that were tricky at best to value in the best of times. So is that an auditor issue?”
Hopefully, my comments will end up somewhere in a column in the paper. In case not, I will summarize them here.
1)The essence of Sarbanes-Oxley is to validate controls exist to mitigate risk that threatens a company’s ability to meet its business objectives.
2)By getting into the sub-prime loan business, these banks and investment companies hoped to profit extraordinarily from above average to high risk activities.
3)The banks, mortgage and investment companies have an obligation to manage risk at all levels by implementing the proper controls to mitigate it, or at least to identify and monitor it so that the level and types of risk being accepted by the company can be properly disclosed to their investors and other stakeholders.
4)An important part of identifying, monitoring and disclosing these risks is to value them according to GAAP and to the extent a reasonable investor would expect. Another would be to reserve according to GAAP and to the extent that a reasonable investor would expect in the event of a change in economic or other circumstances.
5)As part of the external audit process, auditors must form an opinion on whether their clients are complying with GAAP (or the other applicable standards) and whether activities such as valuation of the investment portfolio and estimation of required reserves for potential portfolio losses have been properly performed. Does the client have the internal controls in place to assure that valuations and reserve estimates are correct according to accounting standards and provide a fair presentation in the financial statements of the assets and liabilities of the company?
Add to these obligations, the responsibility of the auditors to ascertain Tone at the Top, that is, whether senior executives have communicated the right tone regarding controls and completeness and validity of financial information so that managers are not afraid to alert them when a strategy or approach is no longer correct or when significant losses are probable or foreseeable.
In other words, serious financial problems don’t usually happen as suddenly as some companies like to make you think, because of foreign competition or some other boogie man for example. They are building up, slowly but surely, based on a lack of internal controls over managing risk.
The reporter asked me about the valuation issue. “Isn’t it a reasonable excuse to say no one could have seen this train coming?” she asked. I reminded her that valuation is one of the quality problems that the Big 4 keep having when the PCAOB comes around. They can’t get it right or don’t think they are doing anything wrong. Unfortunately, the auditors, most of which at the partner level have spent their whole lives being auditors, always one step behind the financial innovators and potential sham artists they are attempting to audit, will always be playing catch up to the financial services masters of the universe.