Not To Be Twistin’ Hay… Auditors Mucking It Up In Ireland

Round trip loans. Director-approved balance sheet manipulation. Window-dressing of accounts at period-end.

“The regulator said auditing firms needed to pay “particular attention” to guidance that it had previously issued on monitoring transactions taking place around year-end, as well as the procedures expected to be followed by auditors…These standards and guidance notes require auditors to scrutinize “material” short-term deposits that are re-lent on broadly similar terms, and loan repayments that are received shortly before year-end and then subsequently re-advanced within a short timeframe.

The guidance notes emphasized that the auditors needed experience and judgment to identify the implications of such transactions, and assess whether they constituted attempts to engage in the so-called “window-dressing” of accounts.”

The Sunday Business Post, March 1, 2009

If that sounds like Lehman Brothers, it’s because the kinds of tricks and techniques used in that case, such as Repo 105, are neither new nor unique.

The PCAOB, the US regulator of public accounting firms, tried to remind the firms at the end of December 2008 of their responsibilities in the “current economic environment.”

In an audit of internal control over financial reporting, the auditor also should evaluate whether the company’s controls sufficiently address the identified risks of material misstatement due to fraud and controls intended to address the risk of management override of controls. Controls that might address these risks include:

• Controls over significant, unusual transactions, particularly those that result in late or unusual journal entries;
• Controls over journal entries and adjustments made in the period-end financial reporting process;
• Controls over related party transactions;
• Controls related to significant management estimates; and
• Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately manage financial results.

Repurchase agreements recorded as loans are legal “round trip” financing tools, often used to both improve liquidity as well as shuffle assets and liabilities at period end to suit management’s objectives.  When disguised as “sales” without proper disclosure and splashed like mud over and over in the face of a skeptical attorney like Anton Valukas, Repo 105 transactions gain a high-class call-girl-type notoriety that’s undeserved given their common whore characteristics.

A round-trip loan was used by Refco executives to hide uncollectible receivables.  Three of their executives, as well as an outside counsel, went to jail for that fraud.

In 2005, Time-Warner paid a $300 million penalty, agreed to an anti-fraud injunction and an order to comply with prior cease-and-desist order and agreed to restate its financial results and engage independent examiner. Their CFO, Controller and Deputy Controller also consented to a cease-and-desist order.

From the SEC press release:

“Beginning in mid-2000, stock prices of Internet-related businesses declined precipitously as, among other things, sales of online advertising declined and the rate of growth of new online subscriptions started to flatten. Beginning at this time, and extending through 2002, the company employed fraudulent round-trip transactions that boosted its online advertising revenue to mask the fact that it also experienced a business slow-down. The round-trip transactions ranged in complexity and sophistication, but in each instance the company effectively funded its own online advertising revenue by giving the counterparties the means to pay for advertising that they would not otherwise have purchased. To conceal the true nature of the transactions, the company typically structured and documented round-trips as if they were two or more separate, bona fide transactions, conducted at arm’s length and reflecting each party’s independent business purpose…”

Time Warner Inc. and its auditor reached a $2.5 billion settlement of the resulting securities fraud litigation. Time Warner paid $2.4 billion, while its auditor, Ernst & Young, paid $100 million.

The regulatory warning cited in the lede quote refers to the regulatory response to the banking scandals rocking Ireland. I’ve written previously about the case of Anglo Irish and their auditor Ernst & Young.  It’s a case that’s eerily similar to Lehman. Ernst & Young, the long time auditor of Anglo Irish, looked the other way as top executives approved loans from the company to themselves, repaid them at period end, then tapped the corporate cash register again after each reporting period.  This went on for several years.  And when exposed, EY refused to cooperate with investigators.

From The Independent, April 25, 2010:

“Anglo Irish Bank, Bank of Ireland, Allied Irish Banks, Irish Nationwide and EBS will cost the taxpayer more than €75bn to bail out after their incompetent and flawed lending drove them to near collapse.

Over the last 10 years, these banks were primarily audited by KPMG, Pricewaterhouse Coopers and Ernst & Young. Auditors are not changed often. In the last decade there have been two changes. Ernst & Young was replaced by Deloitte & Touche at Anglo Irish Bank last year after the bank was nationalised following a series of scandals. KPMG replaced PwC as AIB’s auditor in the wake of the €690m trading losses hidden by John Rusnak at AIB’s US operations in 2001.”

Anglo Irish’s Chairman Sean Fitzpatrick and its CEO both resigned as a result of the scandals and Ernst & Young is still fighting lawsuits and investigations.  By the way, Sean FitzPatrick was at one time a member of the Irish Institute of Chartered Accountants Council.

What a bollix…

The Irish scandals also speak poorly of internal audit at the banks. And whistle blowers, when they tried to poke their heads out of their holes, were not treated well at all.

Again, from The Independent:

“”The internal audit department is enormous within most banks,” said Ms Burton.

“However, in many ways it’s a complete Cinderella; it’s not the glamorous side of banking.”

These well-staffed outfits are meant to monitor the institution’s accounts compliance with internal controls and laws and regulations. Staff members of banks have flagged iffy situations in the recent past and they’ve suffered for speaking up.

Two former group heads of internal audit at AIB, Eugene McErlean and Tony Spollen, flagged issues of concern at the bank in the late-Nineties and early part of this decade. “They were required to act with courage and they did, and they were both forced out of their jobs,” said Ms Burton.”

Ireland and the UK lack the strict Sarbanes-Oxley type prohibitions against auditors serving as highly compensated consultants for their audit clients. The Sarbanes-Oxley Act includes an “Enron” rule. This provision prohibits the Arthur Andersen conflict of interest – they were generously rewarded as consultants and internal auditors for Enron while also acting as their “independent” external auditors.

Finally, as in the United States, the Big 4 firms that dominate the audit roles at the largest banks have also earned big bucks picking up the pieces of the failures, including receiving lucrative contracts with the government and the vehicles created to manage the bailouts. E&Y recently won a government tender to provide loan valuation services to NAMA, a government agency created to bail out Irish banks by transferring the banks toxic loans to NAMA at a reduced price.

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.

PwC and KPMG have also audited other Irish banks and have also been awarded government contracts to advise NAMA. Not to mention that their clients are also the same developers whose loan books are being transferred to NAMA. So we have a situation where the firms are advising their clients on their own loan restructuring, while at the same time advising the government on what to do with those same loans.

PwC was brought in to assess what the losses in Anglo Irish would be. They stated the losses would be €3bn. Turns out the actual figure is just under €14bn.

Sound familiar?

E&Y has recently been appointed to forensically examine what happened in another Irish bank, Irish Nationwide. However, Sean FitzPatrick the Chairman of Anglo Irish used Irish Nationwide as the transferee of his illicit Anglo Irish loans, a window dressing exercise.

Who didn’t catch this?  E&Y as auditors of Anglo Irish.

This video tells the story of the Irish banking crisis or, as I now call the system-wide scandal, “The Financial Services Frauds. They Happened.” My heart raced and my arms goosebumped when I heard many of my own words from the last three years repeated in a melodious Dublin lilt.

The watchdogs who didn’t bark? The Frontline, April 19th, 2010

It’s worth your time to watch if only to fully appreciate that fraud, auditor incompetence and potential auditor aiding, abetting and complicity in managements’ frauds is a global problem.

How do you propose we fix that?

Many thanks to Brendan Brady of Dublin who inspired me to write about the banks in Ireland, provided some great local analysis and color commentary and started me going with quite a few sources and links from Irish media.

Main photo, Dublin, from a syllabus for ENG 41.2 Modern British Fiction to 1950 at Brooklyn College.