"Where were the Auditors?" In this Crisis, Nobody Asks - Because Nobody Cares

In the rural America of my youth, the ultimate symbol for feckless optimism was the farm boy discovered in the barn early on Christmas morning, digging in the manure pile, crying out that, “With all this horse-shit around, there must be a pony under here somewhere.”

My series of meetings last week started with the investment officer of a large hedge fund. Over an extremely dour martini he volunteered his list of those responsible for the nightmares still spreading from the credit markets through the entire world economy:

•    Homebuyers whose aspirations overreached their ability to pay.
•    Mortgage lenders piling up immediate fees for unsustainably aggressive products with neither rational underwriting nor retained risk.
•    Bankers made rich beyond reason by packaging subprime mortgages and other exotic products into slices too complex and obscure to be comprehensible.
•    Ratings agencies whose imprimatur was the key to worldwide distribution of these previously unknown instruments.
•    Investors so graspingly eager that they bought uncritically into the triplet myths of a never-ending real estate boom, ring-fenced exposures and fail-safe yields.
•    And the regulators and politicians whose laisser-faire enabled the entire fiasco.

I waited for him to include the auditors – scapegoats inevitably tagged for blame in every scandal’s aftermath. And waited.

And was still waiting, later that day, when my other friend the insurance executive laid out the precisely identical cast of miscreants  -- with the same unexpected omission.    

In this non-scientific sample, despite the raging furor over accounting standards for fair value and the world-wide lobbying for relief from mark-to-market requirements, nobody was pressing the question, “Where were the auditors?”

There will be days of reckoning to be sure: the Big Four all face new mega-claims -- gratuitous to recite, because taken from the familiar roster of failed financial institutions.

But instead of hauling the auditors into their hearing rooms, the grand-standing politicians are making sport with such fallen executives as Richard Fuld of Lehman and Martin Sullivan and Robert Willumstad of AIG.

My two highly knowledgeable friends both distinguish earlier waves of corporate malfeasance: In this era of turmoil so extensive and widely supported, the accountants didn’t cause the problems in the first place, and in the second, they’re not important or influential enough to provide a fix. 

The value to users of large-company audits began to deflate in earnest in the 1980’s, during the piratical recapitalization of corporate America led by the likes of Ivan Boesky, Michael Milken and Henry Kravis. An unobserved non-event back then, when the predators would lose a deal and lick their wounds and go on to the next deal, was the total absence of claims against auditors.

The simple reason was that no disappointed raider could be bothered to assert reliance on audited financial statements – no such claim would have been credible, when those reports attracted only yawns in the due diligence rooms before being tossed aside.

The trend continued at century’s turn, during the dot-com boom, when stock prices became completely unhinged from traditional financial reporting – when price/earnings ratios were irrelevant to IPO’s and hot after-markets, because flotations did not even require revenues, much less the rigor of real earnings.   

And today, unbidden, the accountants are unheard in the public debates on the causes, accountability and solutions for the credit market debacle. Even on fair value, their predictably rational and sensible position (here) puts them, as customary, on the opposite and futile political side from the forces of influence – unable to stop or even deflect the overwhelming rush to satisfy the world’s bankers specially pleading for the authority to “mark-to-fantasy”.

There are ominous long-term implications in the accountants’ slide to marginalization. Balance sheets loaded with toxic assets that are “marked-to-whatever” will suffer for credibility under the noses of skeptical investors, who know full well that the pile of manure is still fermenting somewhere.

In the same way, the fundamental issue of trustworthiness – on which the entire value of the auditors’ franchise perilously rests – is put under scrutiny when they are effectively sidelined for want of influence and capacity to persuade.

Which marks a shift in the debate on the continuing viability of the profession’s future. Whether the Big Four are “too big to fail” or “too fragile to survive,” it increasingly appears that – if the auditors are so insignificant that they are being ignored, even to be criticized -- then they are “too irrelevant to matter.”

Sad as it is, that bodes ill.

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Comments

[Charles H. Green]

Fascinating. I know I too do not automatically think of the auditors when I think of the list of culprits.

More interesting of course is your central point--that irrelevance is a far greater threat to the profession, or at least to the business of the profession.

Your claim has an echo in the work of Robert Gottman on marriage; the enemy of relationships is not conflict, but disengagement. If you're not in the debate, you're marginalized.

It also reminds me of the old 60s radical theorist, Herbert Marcuse, who wrote "Critique of Pure Tolerance." Basically, if you have all the power, and choose tolerate your enemy's ideas rather than attack them, then you ultimately defeat them more strongly. In his case, he was saying if society absorbs leftist thinking and treats it as just another Time magazine object for curiosity, then you defeat it by trivializing it. In the same way, you're suggesting, mainstream business trivializes accounting.

I like to think I don't completely buy your thesis, that somehow there is still value to be had by looking at concepts of valuation. But I have to confess I don't see anyone leading the charge. Where are the firms themselves? Where is the leadership of a Big 4 firm aggressively pointing out that when mark-to-take-your-pick produces massive P/E multiples for entire market indices, something is wrong, and it's the P not the E?

[Victor N.]

I was alarmed to hear while watching CSPAN footage of Mr. Waxman's congressional committee that the SEC had one person in their risk management / review position for a period of time.

It does not matter how many auditors or audit entities we have if laws are administratively subverted.

Also, I may have it wrong now, but I believe AIG did make disclosures to the SEC appropriately and Lehman had a very strongly written opinion from PWC?

By and large I agree with your post but it sounds like one issue may be that while at least partial disclosures were made, the signifigance of them was lost on people who should have been concerned. We should tackle the issue of technical and reporting complexity so it cannot be used as a smokescreen.

I propose we empower audit firms by requiring them to post alerts about significant findings directly into the EDGAR database with 24 hours of issuing findings. It doesn't seem like this type of reporting is integrated into EDGAR. This would serve the public by bypassing administrative bottlenecks in the SEC (whatever their source).

I would also like to see these entities develop an additional review mechanism that would force independent review the quality of the work peformed by the auditors themselves. This could serve to enforce best practice standards independent of government mandate (see Mr. Snow's semi-silly / semi-valid comments via CSPAN footage).

Lastly, the self-definitional nature of SOX should be sorted out. The ability of external auditors to shape audit controls can be somewhat limited. Companies define their controls and auditors evaluate that companies meet those self-defined standards. The fact Lehman had dumped about 200b in bad paper before going under suggests there may be controls they made business decisions on and controls they audited on. Pure speculation but that was my impression from hearing Mr. Furd testify to Congress.

In any event, as long as we ask audit firms to get paid by the companies for whom they attest, we get what we get. This doesn't mean there is a problem with auditors perse though. I don't think nationalizing the audit function is the answer either. Let's face it, the government failed horribly in its oversight responsibilities. Transparency is lost in the government.

[Kpo Kponsu]

This very interesting perspective about where the auditors were brings the following point to mind. PwC and E&Y have been put in charge to oversee the $700B bailout program. Given that AIG which is in a mess happens to be PwC's audit client. Shouldn't this raise some eyebrows?