A great deal of reliance is placed on auditors by Boards, regulators and the providers of debt and equity capital. But how can these parties know the quality of the auditors' work? Particularly, those not inside the firms being audited?
Understanding What Auditors Do and What They Don't
The first step is understanding precisely what is the role of the auditor. A "clean" audit opinion does not mean that there was no fraud in the company. Nor is it a guarantee that the financials are 100% correct. If you think about it, to get to that level of certainty, the auditor would have to be present at every business discussion and follow each transaction at the company from "cradle to grave".
What the auditors' work should mean ("should" because it doesn't always) is that the auditor has determined that there is a proper system in place that is functioning reasonably. That includes determining that proper accounting principles are applied on a consistent basis, that the assumptions and estimates which affect preparation of the financials are reasonable and that a check of assets and transactions (on a sample basis) doesn't raise any red flags. And finally that the results of operations (income, assets etc) are reported fairly in sufficient detail.
Several factors influence the performance and results of an audit:
- Interpretation of accounting standards and principles: strict, moderate or lax
- Level of skill, experience, knowledge of the partners and staff
- Management of the audit process, e.g., audit plan design, management of staff and workflow, quality of the review process
- Ability and willingness to challenge management's assumptions and estimates
- Ability and willingness to stand-up to pressure from the client or outside parties
- Ethics
The second is understanding that the international firms are structured as partnerships, generally at the country level. So Firm XYZG in the UK is not exactly Firm XYZG in Bahrain. For one thing each has its own dedicated staff with their own level of skills, knowledge and experience. What that means is that there can be differences between one office and another of the same firm.
Auditing the Auditors
So, how can an outsider audit the auditors?
Three ways:
- Use the work of regulators and others who review auditing firms' work.
- Review the end product (the financial report) for quality. While management is ultimately responsible for the content of financials, the auditors have a role to play as well. Is the report clear? Or is the true nature of transactions difficult or impossible to figure out? Does the auditor seem to be condoning presentation at the edge or beyond in terms of accounting for transactions? Do you see a repeated pattern of "easy audits"?
- Prepare a list of auditors for distressed firms. Then identify those companies where the problems were outright fraud, improper valuation of assets, aggressive booking of profits. You're looking for major occurrences and a repeating pattern.
Let's turn to these examples one by one.
Using Regulatory Reports
Unfortunately, such regulatory or other review reports aren't available for every country. To a large extent that limits the utility of this method. But where they are available one may gain some insights. While firms are separately incorporated national partnerships, there is some level of quality control, sharing of expertise among offices as well as tone setting from the top.
It's important to know that public reports of this nature are written in diplomatic language. So it's important to understand the "code" used. The concept is similar (but not identical) to that in the
IMF Public Information Notices. It's also very important to understand the basis for the reports conclusions. In some cases the sample of audits reviewed is small in terms of the total number of audits done. And may not have been selected using statistical sampling techniques. In such cases one has to be careful not to draw a conclusion about just how widespread a failing is.
Reviewing the specific issues for a firm can give an idea of that firm's overall approach and perhaps pinpoint particular areas of concern. One can usually classify the shortcomings as due to (a) lax interpretations of accounting principles, (b) staff inadequacies, (c) work process failures (design, implementation, monitoring and review of the audit), etc.
This exercise can provide another level of insight.
Besides information on a specific firm, these reports may also disclose common problems. If the reports on almost or all of the firms repeat the same themes, this can indicate both the relative frequency and severity of a problem. So, for example. if all firms are being criticized for audit failures on revenue recognition, that's a much different situation than if only one firm is.
On this topic today the UK's
Financial Reporting Council, Professional Oversight Board released its annual
public reports on the audit work four major international accounting firms in the UK. There's a very important word in that last sentence: "public". We can infer from this that there were private reports. No doubt much more direct and to the point.
One firm has been singled out in the press. But if you look at the individual reports you'll see shortcomings in such central areas as:
- Obtaining audit confirmations for assets (one would think in the post Parmalat world this wouldn't be occurring)
- Failure to attend the physical count and inspection of inventory - a very key step in understanding the financials of a manufacturing or retailing company. If inventory is overstated so are profits.
- Technical issues such as going concern qualifications
- Failure to complete partner performance/competence reviews
But note that the sample of audits reviewed was not chosen according to statistical sampling techniques.
What's potentially disturbing here is that these sort of things are being discovered in the UK. One might assume that with the existence of the FRC POB, a legal system that makes it easy for lawsuits, the firms would be on their best behavior. If this is the case, and it may well not be, what then is the standard in other less regulated more opaque markets like the GCC?
Reviewing the Financials Yourself
The second method, reviewing the financials yourself, is admittedly tricky. You've got to have a bit of knowledge about accounting standards and presentation.
Here by way of example are some things that caught my eye. And which two different observers might draw different conclusions.
- The 2009 report of an investment bank in Bahrain. Late in 2009, in what some might see as a vindication of its proven business model, it announced the successful issuance of a US$100 million convertible murabaha. It's only when one reads further into Note 16 that one learns that the murabaha was issued at a discount, though you won't see that word used in the financials. Nor was it in the press release. It's only at the end of Note 16 we learn that proceeds were only US$80 million. Technically, is the information there? Yes. But it must be teased out of the Note. Like that table you bought from Ikea, some assembly is required. Is this really in the spirit of شفافية ? Isn't this material information important to the readers of the financials, particularly shareholders? Shouldn't it be disclosed in plain unambiguous language? Apparently, management and the bank's auditors thought otherwise.
- The 2009 annual report of a conventional investment bank in Bahrain, who some might describe as the grande dame of the industry. During the year, it issued some US$500 million in preferred equity which is duly reflected in its books as of the end of its fiscal year. But a look at Note 6 (Cash and Banks) shows that some US$381 million of that amount is as "cash in transit". What this means is that the funds were received after the statement date. They were not in the bank on the statement date. Reflecting the full US$500 million as paid in equity seems a bit premature. Perhaps this post balance sheet event is more properly reflected in a "Subsequent Event" Note. Note 7 (Receivables) discloses that another US$110.5 million of the US$500 million was also not yet received. So paid in equity has increased by US$500 million but only 1.7% of the amount was received by the statement day. As in the case above, management and the auditors agreed on this presentation.
- The 2006 annual report of the same investment bank. A change in IAS #28 led to a US$354 million charge to retained earnings which dropped from US$528 million to US$170 million. Previously, the bank had valued some of its investments in associates at "fair value" using only comparable transactions using an exemption for assets held for sale in the "near term". The bank noted that "near term" was not precisely defined in the Standard. It reasoned that since private equity and similar investments are held for three to seven years, that period must be what was meant by "near term". Like the cash in transit treatment above this seems a rather conveniently elastic determination. The firm's auditors apparently had no real problem with this approach because they countenanced it for years. But there's more. With that exemption no longer applying, the assets became Fair Value Through Profit and Loss with the methods for determining fair value now also including comparable market values (not just actual transactions). The result of this additional method? A US$359 million charge (68% of 2005 retained earnings). Whether this was properly classified as a prior period adjustment (direct to equity by passing the income statement) statement) is a matter of debate. But the size of the required adjustment does suggest that tests for impairment may also have benefited from generous assumptions. You'll recall that when the restatement occurred (June 2006) macro economic conditions were not particularly depressed. And that over the next two years (a relative boom particularly in the markets where the investments were concentrated) there was no subsequent write up of these assets, lending further credence to the adjustment being more of an impairment.
Involvement in Distressed Situations
- This is fairly straightforward. The initial list can be compiled from the well known names in distress.
- One then looks for cases where there was particularly egregious behavior. And then sees if the same firm's name is turning up repeatedly.
- Two very important points.
- First, firms get into financial distress without there being any defects in audit or any unethical behavior on the part of management. Bad things do happen to good people.
- Second, everyone makes mistakes. It's when one makes a lot of them that the red flag should go up.
- Over the past few years, we've seen some spectacular falls from grace. While some of these were due to (a) poor management or (b) the global economic crisis (lower case "g", please), in others there was apparent manipulation of financials.
- In some of these cases, there have been allegations that loan portfolios were fictions of the imagination, that outside parties controlled the entities overriding what is described as a compliant/supine management, that internal documents, loan files, minutes of board meetings were forged, etc. If these allegations are true, there was massive sustained fraud. Financial institutions may have been run as criminal enterprises.
- In other cases fair values turned out to be vanish with astonishing rapidity. Often in companies that engaged in a high volume of obviously dubious transactions with related parties - buying and selling stock in one another, playing musical chairs with assets. On a scale to suggest that this behavior was the usual mode of conducting business.
- In some other cases, companies abused positions of trust and expropriated client and investor funds for their own use, stuffing those unfortunate parties with the losses or using assets of uncertain quality to extinguish amount certain liabilities. Yet, the audit reports solemnly aver "We are not aware of any violations of local laws". Though perhaps to be fair in some countries local law may not prevent such behavior. It may instead be a sanctioned national sport as some of my "Southern" GCC friends claim is the case in one "Northern" country.
All of the above are of course indirect and not conclusive proof.
But like the mosaic theory of research analysis (in which a bright analyst takes lots of little bits of information about a company to develop a powerful insight into its value), one can
potentially do the same here. And a sense of the quality of financials and audits can be a powerful (though not sole) input to an investment decision.
In the process one also has to apply appropriate weights to behavior. So, for example, one might be more forgiving of some shortcomings than others. It's a bit easier to "understand" an auditor letting some window dressing pass than countenancing related party schemes to pump up investment values. Though it's probably a good idea to be a bit more wary of an auditor who repeatedly demonstrates a "flexible" or "accommodating" approach than one that does not. Each crossing of a "line" makes the next easier.
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