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Auditors - Corrupt and Incompetent


LongHaul
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https://www.wsj.com/articles/kpmg-was-key-witness-as-abraaj-unraveled-1530610201?mod=hp_lead_pos6

This is an example of KPMG's incompetence, etc.

 

But as I get older I think back to how many frauds have been uncovered by the highly paid Auditors.  And I literally can't think of one!  Which is crazy because there are armies of auditors in these fraudulent companies spending a lot of time combing the books with detailed inside information and they still don't catch squat.    I view the auditors as decent for lining up the debits and credits but utterly useless for catching fraud.  If you are relying on big brand name audit firms to vet books of investments, you are making a huge mistake.  You have to do this yourself. 

 

This is a quote from a Coso report on Fraudulent Financial reporting involving 347 alleged frauds (from 1998 - 2007).

 

“Virtually all of the fraud firms received an unqualified opinion on the last set of fraudulently misstated financial statements.”

Page 5 https://www.coso.org/Documents/COSO-Fraud-Study-2010-001.pdf

 

Also Page 5:

"The rate of auditor changes for fraud firms was double the rate of auditor changes for the similar set of no-fraud firms.

Twenty-six percent of the fraud firms versus 12 percent of the no-fraud firms changed auditors between the period

that the company issued the last clean financial statements and the period the company issued the last set of fraudulent

financial statements. "

 

So basically if the Auditors catch it they just leave.

 

Someone asked Chanos who the auditor was on a company and he said "Who cares?"

 

Perhaps I am harsh or perhaps not harsh enough but if you are paid to audit books then you should make sure they are clean and if not disclose what you found to the world.  Auditors (read partners of the firms who are humans) lack courage and moral clarity.

 

As I have gotten older the reputation on Auditors in my mind has gone into the toilet from a higher place. 

 

Such is human condition with tremendous incentives to keep quiet and not admit the fraud. 

 

Caveat Emptor

 

 

 

 

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Corrupt and incompetent are strong words, although self-serving bias is a definite problem.

Easy to identify failures after the fact but what if there were no auditors?

Do you think Sarbanes-Oxley has been useful?

How would you improve the efficiency of audition?

 

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Not my rant, but I think one way to improve it would be change the incentives. Right now the right call for a firm that finds a fraud based on their self interest is to just dump them. I'm not sure how to do that (fines?) But it seems like that'd be the right place to start.

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Not my rant, but I think one way to improve it would be change the incentives. Right now the right call for a firm that finds a fraud based on their self interest is to just dump them. I'm not sure how to do that (fines?) But it seems like that'd be the right place to start.

 

So, functionally, what are you proposing?  That if the auditor finds fraud, they need to publicly disclose it or disclose it to certain parties?  As if you want to make it public disclosure, you will need to fundamentally change the current regulatory regime, as that isn't really allowed.  Though, currently, auditors should be bringing findings about fraud or suspected fraud to the appropriate level of management (per AU 316.79).  In addition, the PCAOB recently passed AS 3101, which will change the wording on auditor's reports for public companies when the standard becomes effective (which will help close the expectation gap of what the public thinks a financial statement audit is and what is actually required by accounting and auditing standards).

 

But, look at it from a service company model as well.  Most public company audits cost millions of dollars.  The big 4 accounting firms do the majority of these audits (I've seen estimates that the percentage is in the mid to high 90s).  And unfortunately, for a lot of businesses, an audit is just a cost of doing business and viewed as a commodity.  So, often times the business will attempt to go with a lower cost provider (and if you start cost cutting, when pressured, people will cut corners or do the bare minimum).  I mean, you can do fraud risk audits (or forensic audits after the fact), but that is an additional set of procedures that is not really encompassed in the current regulations for a financial statement audit.

 

I've heard at least one suggestion that the SEC, and not the company's board, should be the one hiring the outside auditing firm.  But if you entertain that thought, how is the SEC going to pay for it (as their current budget is in the range of $1.6 billion)?  In theory, they could charge all public companies additional fees to cover it.  But then, how would the economics of non-public audits be impacted?  Would all bankers and granters (which are the most likely reasons reasons why non-public entities have audits) have to set up similar pools?  Or would the client still be the company's board (which would probably create different audit models)?

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Corrupt and incompetent are strong words, although self-serving bias is a definite problem.

Easy to identify failures after the fact but what if there were no auditors?

Do you think Sarbanes-Oxley has been useful?

How would you improve the efficiency of audition?

 

I wrote this up because I have been noticing an increase in companies cooking the books.  Perhaps just a coincidence.  And if auditors are taking millions in fees and not doing a key part of their job (finding fraud) then the auditors are like leeches to an extent.

 

Auditors no doubt keep sleazy mgmt in line to some degree and that is worthwhile.   

 

The best solution I can think of is to have the SEC hire the auditors.  That way the auditors would not have to answer to mgmt for their paycheck. Citizens don't pay police directly. Perhaps prorating fraud penalties for each auditors audit in a given year of fraud would help.  Any other ideas?

 

After Sox came out I noticed a lot less cooking the books so I think it was effective.  Of course the stock bubble had burst and Enron and Worldcom shook people up.  Arthur Anderson had failed, which may have jolted the other auditors.  Anderson was particularly bad in my opinion and deserved to fail. 

 

If one wants to learn about fraud you need to learn about forensic accounting.  What are all the ways mgmt can cook the books.  If you were mgmt what are all the levers of this business you could use to pump up earnings? I would have young auditors look at 20+ case studies.  Learn the patterns.  There is the quantitative side and the qualitative side.  And there are tons and tons of ways to cheat.  Catching this stuff can be very hard at times.  But Chanos and Hempton do it from the outside.  The really good fraud spotters that I have seen are generally people who are a bit eccentric and non conformists.  Not the type that fit well in big audit firms.  And you have to care deeply enough and put in the time and effort (ie not be lazy) to figure out the puzzle.  I give a lot of credit to people that out frauds at firms (like the internal auditors at Worldcom) etc and the public shorts.

 

Perhaps my expectations are just too high though.  Sometimes I can just skim the financial statements and pick off something as a high probability cooking the books or doesn't smell right.  I am then surprised that other investors don't see it and get caught in these disasters.  When I was in college I got caught in a few frauds and learned the hard way.  Perhaps it is just reality that many humans are just gullible and auditors are only human.         

 

 

 

 

 

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Not my rant, but I think one way to improve it would be change the incentives. Right now the right call for a firm that finds a fraud based on their self interest is to just dump them. I'm not sure how to do that (fines?) But it seems like that'd be the right place to start.

 

So, functionally, what are you proposing? 

.....

 

Nothing. I'm not an auditor, accountant or regulatory expert. Just making the comment that instead of another 200 pages of prescriptive rules, an incentive change is likely the best solution.  I don't claim to know how to do that, which I tried to make clear.

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The auditor is hired by the BOD and reports to the BOD.

If something is found the BOD is advised accordingly, informally through senior management, and formally through the audit report and 'in camera' session (the what's NOT in the audit report).

 

Tone at the top is set by the BOD, not senior management.

Choosing to 'look the other way' and allowing corruption to flourish is entirely on the BOD, and it is the BOD that you sue. The company directors insurance will cover their liability (within limits), and the insurer will in turn sue the auditors, senior managers, etc. Where there's an incident, there's a negotiated settlement, and the whole thing is swept under the rug to avert a PR related fall in the share price.

 

As an investor, your only real choice is whether you continue to own shares in the company or not.

Alternatively whether you're going to short the company in anticipation of a disclosure.

No points for being 'right', but 'wrong' on timing.

 

SD

 

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This is just another area common on Wall Street where there is massive conflict of interest. Not to mention that companies(just like money launderers) who are engaging in wrongful behavior are typically very generous when it comes to compensating those that facilitate their schemes. I remember hearing years ago about a couple brokers who had a client letting them charge around 5% a transaction, multiple times a month to buy various different equities. A few years later I heard they got caught up in a money laundering scheme with the client who happened to be from South America. Same thing can be found reading through various reports from Mox or Muddy Waters, etc. These audit firms who get paid hundreds of thousands from micro cap companies who eventually then get busted for illicit activity. This stuff is also fairly common with lawyers and "legal opinions". Or doctors writing bogus scripts. Bottom line, is if you want to do something, there's someone out there willing to help you, IF you pay enough.

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...As an investor, your only real choice is whether you continue to own shares in the company or not.

Alternatively whether you're going to short the company in anticipation of a disclosure.

No points for being 'right', but 'wrong' on timing.

 

SD

 

Nice to meet you again here on CoBF, SharperDingaan [ : - ) ],

 

To me, this is the right way as an investor to handle a situation with auditors leaving a company for some publicly undisclosed reason. It is what it is: A red flag. Pack your stuff and leave, if you're not up to short it, before it's getting worse.

 

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I consulted with auditors for specific issues. They are in a tight spot: limited information, and perverse incentives. Difficult to make change when the cards are stacked against you.

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