Fraud Happened: The No-Account Accountants Stood By
The financial crisis is now about fraud.
The word that dared not be uttered, even behind closed doors, has now disturbed the peace of a nascent “recovery.” Why did it take so long for the media, the regulators and the legislators to acknowledge what some of us have known for a while?
“Gentlemen, not one of you could have done this on your own. This was a team effort.” Casey Stengel after the Mets 40-120 season.
Why didn’t the Big 4 audit firms warn that these obscenely over leveraged institutions threatened our financial future? Why didn’t the auditors question, push back, or raise objections to illegal and unethical disclosure gaps? Every one of the failed or bailed out financial institutions carried non-qualified, clean audit opinions in their wallets when they cashed the taxpayers’ check.
Lehman Brothers. Bear Stearns. Washington Mutual. AIG. Countrywide. New Century. Citigroup. Merrill Lynch. GE Capital. GMAC. Fannie Mae. Freddie Mac.
The largest four global audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – have combined revenues of almost $100 billion dollars and employ hundreds of thousands of people. There’s no hard proof they’re completely corrupt, but they’ve proven themselves to be demonstrably self-interested and no longer singularly focused on their public duty to shareholders.
Something is rotten with the accounting industry.
America’s public accountants – in particular, the Big 4 audit firms – aren’t protecting investors. And no one is holding them accountable.
The crisis that culminated in the near-collapse of the global financial system is still the subject of Congressional hearings.
Almost every player has been called to account.
Except one.
Last month the Lehman Bankruptcy Examiner’s report told us that, “sufficient evidence exists to support colorable claims against Ernst & Young LLP for professional malpractice arising from [their] failure to follow professional standards of care.”
This week the Securities and Exchange Commission charged Goldman Sachs and one of its vice presidents with fraud for misleading investors by “misstating and omitting key facts about a financial product tied to subprime mortgages.”
That financial product was a structured collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs, according to the SEC, failed to disclose vital information about the CDO to investors. In particular, John Paulson’s hedge fund, a Goldman client, played a leading role in the portfolio selection process and the hedge fund took a short position against the CDO, without disclosure to Goldman’s other clients.
In one of the most egregious cases of auditor complacence during the financial crisis, Pricewaterhouse Coopers LLP (PwC), the firm that audits both AIG and Goldman Sachs, sat on the sidelines for almost two years while their clients disputed the value of credit default swaps (CDS).
There’s been no public explanation of how PwC presided over the dispute between AIG and Goldman—a dispute that eventually pushed AIG to accept a bailout – without doing something decisive to help resolve it. This long-running “difference of opinion” between two of PwC’s most important global clients was arguably material to at least one of them. Why didn’t PwC force a resolution sooner based on consistent application of accounting standards?
PwC was paid a combined $230 million by the two firms for 2008 and remains the “independent” auditor to both companies.
Gatekeepers? Or foxes in the hen house?
The auditor’s role is to be a gatekeeper. A watchdog. An advocate for shareholders. This is their public duty.
This public trust is subsidized by a government-sponsored franchise. All companies listed on major stock exchanges must have an audit opinion. Audit firms are meant to be shareholders’ first line of defense, and they are hired by and report to the independent Audit Committee of the Board of Directors.
And yet the same audit firms that stood by and watched Bear Stearns and Lehman Brothers fail – Deloitte and Ernst &Young – are recipients of lucrative government contracts to audit or monitor the taxpayers’ investment in the bailed out firms. Deloitte, the Bear Stearns and Merrill Lynch auditor, works for the US Federal Reserve system. Ernst & Young, Lehman’s auditor, is working for the US Treasury on the original $700 billion TARP program and with the Fed on the AIG bailout.
Who are we kidding?
America’s auditors serve themselves. Focused on “client service” not shareholder advocacy, they’ve remained above the financial crisis finger-pointing fray. Call it skillful lobbying or targeted political contributions… Either way, regulators and legislators have been afraid of getting on the auditors’ bad side.
Investment banks, mortgage originators, commercial banks, and ratings agencies have all been questioned about their role in the crisis. And the Big 4 public accounting firms work for all of them.
But when accused of negligence, malpractice or complicity, the audit firms frequently claim to have been duped. Do you believe them? The industry is an oligopoly. That’s a $10 word for what happens when a market or industry is dominated by a small number of sellers who discuss their strategies in order to achieve common objectives.
The Sarbanes Oxley Act of 2002 (SOx) was enacted after the Enron debacle to restore confidence in the audit profession. Instead, accounting firms reaped huge financial rewards while enforcing SOx, until the tremendous cost to America’s businesses forced regulators to lighten up and the auditors to stand down.
But SOx had another insidious byproduct: the misplaced belief that after Arthur Andersen’s implosion, the remaining four global public accounting firms were too important, and too few, to fail.
This fear of auditor failure precludes any regulatory or legislative actions that might precipitate the loss of another large accounting firm. What do you get when there’s no timely or significant regulatory consequence to repeated auditor malpractice and incompetence? Moral hazard. “Too few to fail” has been as detrimental to capital markets as the notion that some financial institutions are too big to fail. Shareholders are harmed and investors lose confidence.
Every one of the audit firms is a defendant in lawsuits for institutions that failed, were taken over, or bailed out, in addition to several $1 billion plus malpractice, fraud and Madoff-related lawsuits. Any one of these “catastrophic” matters could threaten their viability. However, regulators and the worldwide business community are ignoring this threat or, worse yet, promoting liability caps. Limiting liability only exacerbates moral hazard.
Can a crisis caused by “catastrophic” disruption in audit service delivery be any worse than the one they never warned us about? Why not face fears head on and start re-writing the audit blank check – ineffective audit opinions – before the plaintiffs’ bar does it for us?
“It is not questionable that the dark always comes. What is questionable is the fact it blinds us, for there is always light in the world.”
— Ambrose Fetch
“It is not questionable that the dark always comes. What is questionable is the fact it blinds us, for there is always light in the world.”
— Ambrose Fetch
Do you suppose Mizaru, Kikazaru and Iwazaru developed the Executive Leadership Programs for the Big 4? Monkeys all.
Hi Francine,
Great article Francine,which is expected from you.Thank you for informative article.
You are absolutely right. Refering back to the link of Goldman Sach’s,i mentioned that RBS was an institutional investor & lost 545m pounds(US$ 800m).Paulson & Co., the hedge fund was the biggest winner in Goldman Sach’s debacle.The regulators in UK & Europe,along with other parts of globe have started investigations in Goldman Sach’s,but it’s too little too late.The damage has already been done & these investigations will bring nothing substantial.The global recovery has been hampered by Goldenman Sach’s.The Wall Street in NY was down in Friday trading & the sharemarkets opened in red (losing 100 points) in ASX (Australia).The first market to open on monday in the world followed by Asia.Now the European markets are down in early morning trading & US Nadaq & Dow Jones is going to open soon,but in red where it left on friday evening.
In my opinion the world is going for double dip recession.I am predicting another one in few years,because we haven’t learned anything from this recession.
Umair(Big 4 ABAS @EMEA)
The Nasdaq/Dow Jones in Wall street NY US effects other share markets around the globe.It was a good trading day on friday here,until saturday morning here Wall street closed in red.Today markets opened in red courtesy Goldman Sach’s & shed 100 points in few mins.Now i am looking up to NYSE to open in US, in 5 hrs time.Goldman Sach’s is a global client in Banking & Capital Markets & yes i agree Big 4 hires 100 of 1000;s of employees globally from internee to Partner & they have to conduct audits of multinational firms/banks under Global Audit Methodology(GAM).
Francine,
Interesting post. I think your points are valid for the most part and should be voiced. But what is the answer? Seems like more government regulation is not the answer as the SEC sure has had their problems. Even if the audit profession became more active, forcefull and voiced concerns, company mis-management would not always be prevented. Fraud, greed was part of the problem but so was poor judgement by AIG, GS, etc. management and board memebers. And as we see it is oftern hard to hold them accountable. I agree the accountants could do more and should but this is a tangled web and it’s not fair to lay all the blame on the accountants and to imply a bit that they could have prevented all this. The blame needs to be spread around the companies themselves, the government and even the public demanding higher returns on their stock investment.
Mark
Having worked with auditors and audit committee’s the auditors are too politically attuned lately to give bad news to their clients. For what ever reason they give, they walk a fine line of disclosure. I am not saying that they can not be frank and forthright in certain matters, but in other areas they downplay their advice to not offend the management paying the bills or influencing their return next year. We need a better system between gathering information and drawing conclusions. This could very well be in the makeup and work done in the audit committee.
And you could not be more correct. The “F” word has been conspicuously evaded by everyone including the lightweights on the FCIC for years. The Goldman blow-up finally gets the REAL story of the crisis out into the open. I don’t know why everyone is so surprised–this kind of client/customer deception has been going on for decades, highlighted in the 1990’s by the Merrill fraud against Orange County, CA… What happened with subprime mortgage-backed CDO’s is just the same activity on steroids. GS is by NO MEANS the only culpable party This case WILL prove to be the mere tip of the iceberg. I’ve written on it in a book just published by Wiley: http://www.wiley.com/WileyCDA/PressRelease/pressReleaseId-71937.html
Yes, that was same term I heard again and again from the Big 4 partners for the past 10 years – “The government won’t let us fail, because there are only 4 left. There is no other choice out there”… “Too big to fail” or “Too few to fail” is the ultimate problem that causes the auditors to be lazy and irresponsible. Someone needs to do something about it…
Francine,
I haven’t commented here in a while, but recently saw your comments on another blog regarding how the auditing profession should be restructured. My guess is that your professional experience has been primarily with large public for-profit entities. I wonder if you would have the same opinions about having the government play the primary role in auditing, if you had more experience with governmental accountants and auditors. As a general rule, the most talented indivduals will work where they are most highly compensated. That is not in the governmental sector of auditing. Enough said.
That is not to say that the entire auditing profession should not be held accountable for its own failures. I am intrigued by what Jim Peterson has said about the lack of vision and fortitude among the leadership of the Big 4 firms. I would suggest that this problem may be even more severe at smaller firms.
Does the assurance business need to be redesigned? From my perspective, yes. But why are no answers coming from inside the profession? To tackle this, I think you need to address the cultural issues in accounting firms — the control environment, in accounting speak. This seems to be an area that most accountants are uncomfortable with, because it can’t be assessed quantitatively. It is essentially a human issue, and most accountants don’t choose their field because they are comfortable in that arena.
I want to hear more about the Stockhold Syndrome and CPA firms. Take a stab at the psychological profile of successful accountants in large firms. Does this risk the danger of stereotyping accountants? Perhaps, but possibly, there is a good deal of truth in the portrait. Also, you should not underestimate the effect that CPA firms have on the accounting profession as a whole, because many accounting departments are staffed with people who have come from that culture.
Is anyone surprised? Think about how much hand wringing and number twisting is done on an audit client with maybe a 1M in fees. Now consider two entities combining for 230 MILLION in fees. Hell they will sell their families into slavery to keep those kind of fees away from the other big 3. Who wants to be the partner to blow the whistle on such a monstrous account? You would be blacklisted. The problem is that at the top 1-2% of the big 4, SEC, PCAOB, is all, for lack of a better word, incest. Major players at the big 4 firms are advising the SEC, on committees, making suggestions, designing policies and standards. Major bankers are involved in crafting Washington policy, deciding what should be enforced and how. We are literally letting the foxes build the henhouse. They are aware of it and really don’t care. Because the higher up you get, the more complicated the schemes are. And the more gray area exists. They bank on the fact that the average American has absolutely zero idea what they’re up to. For that matter, a good deal of CPA’s can’t figure it out. Do we know that Goldman, Lehman, etc. were doing something immoral? Of course. Can we prove it? Maybe. Will anything happen? Probably not. We can lay the facts bare, and the majority of the American public will not be able to decipher it. This stuff will drag on for years, to the benefit of the corporations and big 4. The pain will subside, people will forget, little will be done.
Great article! However I was not surprised by the revelation because the accounting firm have shrunk in size from the Big 8 to the Big 4 which makes it easier for the companies to pay the fee to get what they wanted.
For the issue of the leveraged institutions can be traced to the S.E.C. allowing the banks to hold less capital for the loans they purchased under the Basel II agreement in 2004 which went from 12:1 to 30:1 and even the Fed under Greenspan accepted the fact that securitization made banking safer and allowed them to hold less capital than they should have. The key word for this mess is: liquidity because many of the contracts required the companies to make spot collateral to cover the loss of the valuation of the CDOs. Since CFMA has created a loophole that allowed financial firms to trade this without the use of the clearinghouse to make it transparent which even the SEC and CFTC were prevented from regulating it.
While is true that the auditors should have point them out but you are dealing with management that want to show to the shareholders how the companies are doing in short term which, in turns rewards CEO and management more money in forms of bonuses. The shareholders didn’t care how the company made money as long as it was reporting profit.
In a classic book about the accounting profession some forty years ago, Unaccountable Accounting: Games Accountants Play, Abraham Briloff recounts a supposedly true story suggesting the primary criterion corporations employed in selecting their public accounting firms. In the event that you may not have heard this story, I wish to tell it here and now, since it may still have relevance in our current times.
Once upon a time in accounting land, there lived eight big giants: Arthur Andersen; Ernst & Ernst; Haskins & Sells; Lybrand, Ross Bros. & Montgomery; Peat, Marwick, Mitchell; Price Waterhouse; Touche, Ross; and Arthur Young. These public accounting firms were regarded as gods by everyone in the business community and the accounting profession. Whenever they spoke, everyone listened. And whatever they signed, the business community accepted as gospel.
An executive of a corporation wishing to go public interviewed the partners of these various “Big Eight” accounting firms. He needed the seal of approval of a Big Eight firm on his financials in order to enhance the valuation of his corporation’s stock offering. In the interview, all he asked of the partners from each public accounting firm was the following simple question: “How much is 2 plus 2?” Virtually all of the partners of the Big Eight accounting firms, thinking that the executive was a complete idiot, simply replied, “4, of course”,— that is, all but one partner from a Big Eight firm, who paused and remained silent for a considerable period of time, not replying with the obvious answer that the other interviewees had immediately spurted out. His response, after some serious reflection, was, “What number did you have in mind?” Needless to say, upon hearing what he wanted to be understood, the executive selected this partner’s public accounting firm.
Back then in 1972 when the book was written, Abraham Briloff did not think very highly of GAAP (Generally Accepted Accounting Principles), preferring his own acronym, CRAP (Cleverly Rigged Accounting Ploys), to describe the profession’s accounting methodologies. In fact, Briloff felt that the Big Eight firms in particular had been selling out their requisite professional posture of independence, especially in regard to their audit clients.
The question today, of course, is how much has really changed in the last 40 years? I would be interested in hearing Briloff”s reply; I suspect that he might say, “not very much”. Abraham Briloff was, and remains so in his writings, an important gadfly and watchdog of the accounting profession, a voice of its collective conscience. Regrettably, as long as accounting firms are hand picked by their clients, the question raised by Briloff many years ago will continue to haunt, if not tarnish, our profession: how truly independent and objective can accountants afford to be? Was Briloff too cynical believing that we as professionals would never bite the hands that feed us? Or are we too willing to be naive?
I was trained on stories about Arthur Andersen. Here are a few quotes from the book, “Inside Arthur Andersen: Shifting Values, Unexpected Consequences” (Squires, et al, 2003)–
Within the firm, stories circulated for decades after his [Arthur Andersen’s] death about how he had done the right thing when it was NOT the only choice but when it was the less profitable or more difficult choice. In one such story, Arthur faced a client who had distorted earnings by deferring large charges, rather than reflecting them in current operating expenses. The president of the company … demanded he change the audit certification to suit the client’s version of the truth. Arthur replied, ‘there is not enough money in the city of Chicago to induce me to change the report.’ Arthur lost the client but gained something more important–a reputation for straight talking. …
Arthur was a realist and maintained some skepticism of client management. … He was well aware that straight reporting meant that auditors needed to check reality and make sure that the material facts reported by the client were accurate and required that an auditor understood ‘the facts behind the figures.’ … it is the auditor’s job ‘to ascertain the factors that contributed to the operating results and form a business judgment as to how to improve the good factors and eliminate the bad.’ The Andersen reputation for resisting misleading reporting and telling it like it was grew, and getting the Andersen name on your company audit became increasingly desirable.
Arthur E. Andersen took ownership of the audit and he was prepared to stand behind his work. The generally accepted position on audits the first quarter of the 20th century was that they belonged to the client. But Arthur E. Andersen reasoned, because audit materials carry the Arthur Andersen & Co. name, audit reports should belong first and foremost to the firm, not the client. As auditor, he was obligated to determine what was in the audit. Arthur E. Andersen had all audit opinions signed in a handwritten signature as ‘Arthur Andersen & Co.’ and, later, with ‘Arthur Andersen & Co.’ plus the responsible partner’s name below it. If any errors or problems were found, they would be corrected, and Arthur Andersen & Co. would pick up the associated costs if the firm was at fault.
Obviously, toward the end of the 20th century things deteriorated from the gold standard of audits described above (pages 32-33 of the book, if anybody’s interested). But wouldn’t it be nice to get back to that level?
— Tenacious T.
The CPAs could not have prevented the financial crisis. CPAs do not have the responsibility for risk management at banks. But they do have the obligation to audit financial statements to make sure those financial statements are fairly stated. And they failed to do this. E&Y couldn’t have saved Lehman Brothers from itself. But if they had done their job and not delayed the day of Lehman’s ruin by signing off on Lehman’s financials, the total losses to creditiors would have been a lot less.
Dear Tenacious Truman,
I appreciated the interesting comment about Arthur E. Andersen. Thank you for informing me about the book, “Inside Arthur Andersen: Shifting Values, Unexpected Consequences”. Apparently, that’s a must read today because, as Yogi Berra used to say, “it’s deja vu all over again”.
Will the result be new legislation passed, a new set of regulatory requirements, a new audit reporting process, and a new billable hours windfall for the fantastic four. Will we thus be entering “SOX Syndrome” into the lexicon.
Re Truman #15
it’s worth remembering that the SEC beat Andersen up over their two-opinion (“presents fairly” and “in accordance with US GAAP”) audit report. In 1962, faced with clients refusing to change their accounting, Andersen decided to stay in business rather than go bust.
It’s all there in Zeff’s excellent paper on “presents fairly” opinions.
http://www.ruf.rice.edu/~sazeff/PDF/Primacy%20AP%20pdf.pdf
nothing will happen until the justice department and FBI, Federal Reserve are purged of Bush’s Lackeys ..read how he appointedf Lawyers of his kind to these positions. then check out the bankruptcy code that was rewritten during his tenure. Then impeach Obama for not asking for resignation from Geitner( who is in cahoots w/ the investment banks and didnt do his job as a Federal reserve governor),, reappointing Bernanke who sat still as the crap implodedm for not busting up these TBTF banks, the list goes on Obama isnt the right man for this job at this time he wants to be LIKED and he also a business helper so he wont hurt them, ends these insane wars. the list goes on and on..