The Role of Auditors in the Financial Institution Crisis

There is a read-worthy op-ed dealing with the role of auditors in the financial institution crisis specifically, and as independent watchdogs guarding the public interest more generally.  Prem Sikka, Accounting for the Auditors, Guardian.co.uk, September 18, 2008.

Put very generally and in my own terms, Sikka's point is this.  We think of auditors as guardians at the gate, watching over firms with the public interest in mind.  But in reality they are paid lackeys of the companies that hire them.  To the tune of millions a year (in the case of Ernst & Young's audits of Lehman Bros, more than $30 million for 2007), auditors review company records and file clean bills of health.  Yet those same companies go under for risks that should have been foreseeable by the auditors at the time of the audit.

Sikka describes the Lehman audits by Ernst & Young, and the fees E&Y collected for those audits, as follows:

"On January 28 2008, the firm gave a clean bill of health to Lehman accounts for the year to November 30 2007. ... Lehman Brothers filed quarterly accounts with the SEC for the period of May 31 2008 and on July 10 2008 and these ... too received a clean bill of health. Despite the deepening financial crisis, auditors did not express any reservations about the value of the derivatives or any scenarios under which company may be unable to honour its obligations. Just two months later, Lehman collapsed."

"During 2007, Ernst & Young collected fees … of $31,307,000 from Lehman Brothers, compared to $29,451,000 for 2006. The fees for 2005 and 2004 were $25,324,000 and $24,748,000 respectively."

 

Clearly, auditors earning such significant fees from auditing and tax services will find it difficult to provide bad news to companies and their investors and regulators.  Sikka's suggestion is to return to truly independent audits conducted by the regulatory agency (the SEC). 

Thanks to my colleague Mike Mcintyre for the tip to the article.

Comments

[Frank Schoenburg]

I couldn't help but think about the FDA while reading this post. The systemic failures of the FDA and audit firms parallel each other perfectly.

The auditors at E&Y give a clean bill of health to financial statements that insiders know are dirty. Meanwhile the FDA approves drugs that are insiders know are dangerous.

The solution in both cases is to have government entities that provide true independent audits - whether those audits are drugs or financial statements. Vioxx anyone?

[andy]

"Sikka's suggestion is to return to truly independent audits conducted by the regulatory agency (the SEC)"

Can the SEC really send bean-counters to every company? And companies will still need outside counseling for "grey" areas...in the IRS context, getting a PLR takes a while...can the SEC really offer thousands of determinations on how to account for various expenses/income items for thousands of corporations?

something tells me financial statements audited by the SEC are not coming any time soon.

[LindaMBeale]

Andy, I agree that it is not clear how realistic Sikka's solution is. The IRS, of course, audits very few taxpayers--I believe it is something under 2%, and those audits miss many issues or miss details of issues discovered, so that taxpayers are able to "play the audit lottery" by taking aggressive positions that they know would not be more likely to win than not if thoroughly audited. An SEC audit system similar to the IRS audit system would not appear to provide the reassurance that is needed that public companies are reporting properly.
That said, it is clear that the "fees for service" system with accounting companies that are closely allied with the firms they audit is not working. I tend to think that a change of paymaster might be effective--let companies pay into a fund with a fiduciary acting in the public interest who arranges for the audits. The fiduciary becomes the client, not the audited company. That would require considerable change, including rules requiring transparency and access to records, etc. But I think it would work much better than the current "clean audit for hire" system.

[andy]

well, the beauty re: financial statements is that there are thousands of lawyers who indirectly work for the SEC for free, i.e., plaintiffs/securities lawyers....if you want to scare companies into keeping their books straight (assuming that that's the problem) then relax the statutes relating to securities litigation...that will be far more effective than sending a team of grunts from the SEC to review ledgers.

anecdotaly, in my experience the accountants are the extremely conservative one these days...i understand things were different in the late 90s, but today it seems like getting accountants to "sign off" is constantly a challenge. that's from the tax side, however...perhaps there is a different attitude regarding other functions (e.g. earnings projections, etc.)

[LindaMBeale]

I tend to agree with you Andy. The "free marketarian" ideology led to considerable impediments to securities litigation, protecting companies from those who might have been able to make them more accountable through lawsuits. Like tort "reform" and other efforts to deregulate, these impediments are highly questionable and most likely served primarily the managers. Relaxing securities litigation standards would be a good start in re-establishing some sense of accountability of corporate managers to the public.

[John Bill]

Dear friend,

Realy it is very useful post , Accept my sincere thanks and appreciation

John Bill

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[Davinder Kohli]

I think we need to think outside the box and therefore like the suggested solution. the number of financial institution is not that many. Regulators have been operating blindfold because they don't have full access to all data. That can only be remedied when they assume complete responsibility for audits. I think the UK is already on that road. They have a body called the Audit Commission which appoints and remunerates auditors to all public bodies. These auditors are not allowed to sell other services, have to report on financial irregularities and also the entity's efficiency and effectiveness. I just can't see how acocunting firms under the current audit model can deliver useful audits. They can't bite the hand that feeds them and we have given them too many liability shields.

[Davinder Kohli]

You might have seen this. So many auditors so little use

http://www.guardian.co.uk/commentisfree/2008/oct/07/creditcrunch.banking