Hello Out There! Any Internal or External Auditors Reading the News?

                   When Accounting and Regulation Fail Shareholders

Recent events should cause smart accountants and auditors to discuss their industry and what changes they (and their clients) should undertake soon. Specifically, let's look at two notorious events (Bear Stearns and the District of Columbia's Office of Tax and Revenue) and one older event (Enron).

                                       DC Office of Tax and Revenue

Employees of this organization allegedly found a loophole in a property tax refund system and routinely cashed millions of dollars of fraudulent refund checks. This occurred even though a $100 million system had been installed and that same system won awards for its 'outstanding technology'. In this case, an auditor noticed in 2006 that a critical linkage between the system and the check processing process was missing. In this case, an auditor not only flagged the potential problem but helped start the process that led to the arrest of 10 persons. (For more on this case: see Computerworld, March 10, 2008, "D.C.'s Tax System Won Plaudits - but Didn't Stop Alleged Fraud Scheme").

In this situation, auditing did its job. It documented control problems and flagged the potential for fraud.

                                                Bear Stearns

The Bear Stearns collapse appears to be due to two principle factors: an old-fashioned run on the bank and the aftereffects of failing hedge funds and portfolios of poor quality mortgage loans (i.e., high risk) loans. If you'd like a great recap of how this scenario occurred and of the numerous instruments Bear and others used to supposedly offset risks, take ten minutes and read: http://www.moneyweek.com/file/31699/subprime-mortgage-collapse-why-bear-stearns-is-just-the-start.html This article makes clear a very complicated set of financial instruments that make transparency next to impossible for an ordinary investor to follow. For example, do you know what these are:

• Mortgage-Backed Security (MBS),
• Collateralized Debt Obligation (CDO),
• CDO traunches (Equity (high-risk - also known as "Toxic Waste"), Mezzazine (moderate-risk & also viewed as Toxic Waste), Investment Grade (low-risk)),
• repurchase agreements
• reverse repurchase agreements
• Hedge Funds and the number of times their leverage their investment in these instruments
• Synthetic CDOs
• Credit Default Swap (CDS)

In effect, what appears to be going on is this:

• 6 million US homes were purchased or refinanced with little money down and by poor credit risks (the sub-prime market). Estimates suggest many of these homeowners are now underwater on their notes and may be moving to foreclosure
• Lenders completed these transactions and offered attractive financing rates are they could bundle an assortment of notes into a large bundle to be sold on the equity markets. This debt was broken out into three groups (see above: Equity, Mezzanine and Investment Grade) and sold to hedge funds.
• Hedge funds did well with these as long as housing prices increased. Hedge funds used the increased value in these instruments as collateral to buy more of this stuff. Unfortunately, when housing prices fell, hedge funds that were overly leveraged would fall, too. The easiest similarity to this is when stock buyers use margin to buy more securities than they have cash/assets to do so. If prices fall, they get a margin call and may lose all of their pledged securities. When you use margin, you can also lose more than you're worth.
• Risk for these instruments was sold as another financial instrument much like an insurance policy.
• In a down market, overly leveraged firms and hedge funds get creamed. The lack of a strong secondary market for selling these 'instruments' can trigger a free fall in values/net worth. Bear Stearns has seen two of its hedge funds, which bought/held some of these less than investment grade instruments, fail. Estimates put the bail out/losses for these two funds to be in the $25-30 billion range combined.

I pulled up the Bear Stearns annual report as of November 2006 and read it. I concluded that:

• The appearance of special purpose entities is littered throughout the report. SPEs were at the root of the Enron difficulties as these entities are not publicly traded, have limited independent oversight and have significant inter-company connections. SPEs are enough to wave me off many firms; however, the sheer magnitude of these and their interconnections is hard to fathom even in this annual report.
• What neither the management of Bear or its auditors produced was a flowchart that shows the actual legal entity structure of Bear, its subsidiaries, affiliates, SPEs and other related entities. For shareholders to make informed decisions, then material liabilities, sureties, guarantees, fund commitments, risks, etc. between entities need to be specifically identified. Without this guidance it is hard for anyone to understand how convoluted and risky a given firm really is.
• There are 122 pages in the annual report (see: http://www.bearstearns.com/includes/pdfs/investor_relations/annual_reports/annual_report.pdf ) please take a look at pages 50, 52, and 62-64 in this pdf file.   

Sarbanes-Oxley legislation emerged out of the Enron collapse. It was supposed to increase transparency, improve controls, and reduce investor risk. While the Bear books may meet the letter of the law and comply with accounting standards, they do not, in this person's opinion, offer full transparency into the potential risks investors face with this stock. Specifically, it would take hours/weeks/years, if ever, to understand the full scope of inter-related transactions and the nature of risk associated with them in each of the SPEs, subsidiaries, etc.

Auditors have maintained that their tests can't detect all frauds (that's true) and they can't predict future business success either (that's also true). They maintain that their efforts verify the veracity of the financial picture of the firm at a given point in time. Investors look to auditors to provide transparency into a company's books but auditors aren't paid by investors. Company management and/or the board do that. That's unfortunate as it's transparency that's really needed and nothing that accountants produce today is materially relevant in a transparency situation. Had there been more transparency into SPEs, Enron would have been caught earlier. That may be the case for Bear, too.

The accounting industry should be embarrassed by this. Sure, Luca Pacioli didn't have SPEs to contend with in 1493 but I'm sure he would have come up with a way to see through the shrouds of secrecy that still shield too much of their risks from shareholders. Accounting leaders may defend their actions but their industry seems to be growing less and less relevant to shareholders and today's problems. It isn't effective in detecting situations that can lead to business failure and its shortcomings are going to trigger more bailouts by the government. Accounting, sadly, is woefully behind the times and irrelevant.

Worse, accountants should be embarrassed by the fees they've collected documenting controls and other Section 404 work spawned from SarbOx. Has it reduced shareholder risk? no. Has it helped the companies who had to comply with these requirements? Probably not. Has it enriched the partners of auditing firms? Absolutely. Accounting is clearing benefiting from regulation but shareholders aren't. They indirectly pay for all of this control documentation while accountants are not focusing on where the real business risks lie.

We don't need more regulation and accounting standards. We need innovation in the accounting industry and we need accountants willing to develop new forms of communication beyond the balance sheet, income statement and sources/uses of funds reports. Innovation and Accounting are two words that rarely exist in the same sentence but should.

Bottom line: Did the accountants do anything wrong at Bear? Probably not. Could they have done more? In my opinion, absolutely yes. 

Comments

[Dennis Howlett]

Brian - your factual analysis of the situation is correct but I'd draw your attention to Carlyle where audit reports issued just days before collapse gave a clean bill of health. The auditors most certainly failed because they can't figure out how to deal with SPEs but chose to remain silent despite the assets are very difficult to value. Hence the rescue at pennies on the dollar.

[Debt Rescue Relief]

Hedge funds are used as collateral as housing properties , with inflation the hedge funds can be used as alternative .