Monday, November 28, 2011

Why have auditors at all?

SIX months ago, accounting firm PricewaterhouseCoopers (PwC) said MF Global and its units 'maintained, in all material respects, effective internal control over financial reporting as of March 31, 2011'. A lot of people who relied on that opinion lost a lot of money.
By Jonathan Weil

MF Global filed for bankruptcy on Oct 31. Last week, the trustee in the liquidation of its United States brokerage unit said as much as US$1.2 billion (S$1.6 billion) of customer money is missing, perhaps more. Those deposits should have been kept segregated from company funds. It seems they were not.

What is the point of having auditors make reports like this? And are they worth the cost?

When an auditor certifies that a client's internal controls are effective, that is supposed to mean the company can do basic functions like maintain accurate financial records, detect unauthorised transactions, and keep track of its receipts and expenditures. We know MF could not do these things during the final days before its bankruptcy filing, when former New Jersey governor Jon Corzine was still its chief executive officer.

'Their books are a disaster,' Mr Scott O'Malia, a commissioner at the Commodity Futures Trading Commission (CFTC), told the Wall Street Journal in an interview.

The newspaper also quoted Interactive Brokers Group CEO Thomas Peterffy as saying: 'I always knew the records were in shambles, but I didn't know to what extent.' Interactive Brokers backed out of a potential deal to buy MF last month after finding discrepancies in its financial reports.

So, to believe PwC got it right when it blessed MF's controls in May, you would have to accept the notion that MF's controls were effective in March, and did not start going bad until some time later.

Although we should not rule out anything, this scenario seems implausible. One lesson from the 1980s savings-and-loan crisis is that when a financial institution fails, it is almost always true its internal controls were poor - and had been so for a long time. Otherwise, it would not have failed.

There is more at stake here than the missing US$1.2 billion. Besides MF, other companies that use PwC's New York office as their auditor include Goldman Sachs and JPMorgan Chase. Both banks presumably are too big to fail, meaning taxpayers would be on the hook if they ever blew up. If PwC cannot spot control weaknesses at a relatively small shop like MF, which had US$41 billion of assets, it is a bit much to expect it would catch anything materially amiss at Goldman, which has US$949 billion of assets, or at a serial acquirer such as JPMorgan, with US$2.3 trillion of assets.

Fortunately for PwC, there is no better alternative. What can Goldman or JPMorgan do? Switch to KPMG? Ernst & Young? Deloitte & Touche? Their track records are no better.

The reason MF had to get an outside audit report on its internal controls was that the Sarbanes-Oxley Act requires it. That law was enacted in 2002 in response to a wave of audit failures at big companies such as WorldCom and Enron.

Thanks in part to the new workload, audit fees at the Big Four accounting firms skyrocketed. So, too, did the number of financial restatements by public companies, which seemed to show the auditors were drilling down and catching lots of errors. For a while, it looked like the new rules were working.

Then a backlash hit. Corporate executives, lawmakers and even Securities and Exchange Commission officials complained the auditors were too strict. The number of restatements plunged. Audit fees stopped soaring, and overall have been little changed since 2007, according to a July report by Analyst's Accounting Observer editor Jack Ciesielski.

Many companies' audit fees plunged, suggesting auditors there were doing less work. In 2007, MF Global paid PwC US$17.1 million in audit fees. By this year, that had fallen to US$10.9 million, as warning signs about MF's internal controls were surfacing publicly.

In 2007, MF and one of its executives paid a combined US$77 million to settle CFTC allegations of mishandling hedge-fund clients' accounts, as well as supervisory and record-keeping violations. In 2009, the commission fined MF US$10 million for four instances of risk-supervision failures, including one that resulted in US$141 million of trading losses on wheat futures.

Suffice it to say, PwC should have been on high alert.

On top of that, PwC's main regulator, the Public Company Accounting Oversight Board, released a nasty report this week on PwC's audit performance. The agency cited deficiencies in 28 audits, out of 75 it inspected last year.

The tally included 13 clients where the board said the firm had botched its internal-control audits. The report did not name the companies. One could have been MF, for all we know.

In a response letter to the board, PwC's US chairman Bob Moritz and US audit practice head Tim Ryan said the firm is taking steps to improve its audit quality.

But the point of having a report by an independent auditor is to assure the public that what a company says is true. If the reports are not reliable, they are worse than worthless, because they sucker the public with false promises.

Maybe, just maybe, we should stop requiring them altogether.