Services Safari

Why Auditing Should Be Continuous...

                        Lehman Gets Burned for $400 Million

Here's more evidence that:

• crooks can best most controls companies put in place to catch fraud
• Wall Street's woes aren't over
• Auditing needs to be more automated and continuous

In an article in the New York Post (see: http://www.nypost.com/seven/03302008/business/400m_con_job_104125.htm), the Wall Street firm Lehman Bros. got taken in to the tune of $400 million. Did auditors catch it? No. Did SarbOx controls do their job? No. Hmmmmmm

Who to Blame for Skills Shortages

          Are CIOs the Makers of the Tech Skills Shortages They Bemoan?

Check out Allan Alter's piece in CIOInsight (http://www.cioinsight.com/c/a/Opinion/Blame-CIOs-for-the-IT-Skills-Shortage/). Alter lays a goodly portion of the blame squarely at the feet of CIOS. This is an interesting read and one educators, recruiters and others should read.

Call to Action: Need for Accounting Industry Reform

                          KPMG and the New Century Case

The Accounting Industry has an image problem and it's getting worse everyday. Let's recap just some of the issues facing an industry that changes with the speed of the tectonic plates:

• The industry failed in several colossal audits prior to and including the Enron situation. Audits at Waste Management, Sunbeam and others were frequented identified.
• Sarbanes-Oxley legislation was intended to prevent future problems but it clearly hasn't.
• Additional business failures/accounting problems continue to arise.
• SPEs (special purpose entities) are still beyond the grasp of the accounting industry.
• Investors are still getting surprised and losing money.

Today, let's look at New Century and KPMG. In a story titled: "Official: Lender's action set off 'bomb'" (source: Associated Press, March 27, 2008), the AP reported the conclusions of a court examiner looking into the 2005 and 2006 books of New Century. The article offers these disturbing comments:

"Bankrupt mortgage lender New Century Financial Corp. used improper accounting practices while making risky loans...engaged in at least seven improper accounting practices...lender failed to take appropriate steps to manage rising risks caused by the company's aggressive approach to originating loans, often to borrowers who couldn't afford them...KPMG LLC enabled some of the improper practices to continue"

The article reported that KPMG disagreed with the report's conclusions. To read the piece on the Chicago Tribune's site, click here: http://www.chicagotribune.com/business/chi-thu_kpmgmar27,0,1287820.story

What are we seeing in the Accounting Industry today?

1) Do accountants innovate as fast as the best and brightest in Wall Street do? NO WAY. The truly clever people in business finance and accounting are moving at a rate far in excess of that guiding the accounting industry. Clever people are the perennial nemesis of auditors and that's why auditors must do more than slowly evolve, they must outflank, out-innovate and anticipate the next tricks of those who wish to obfuscate, deceive or cheat.

2) Do universities teach the most relevant, timely skills that future accountants and auditors need? I'm checking with some authorities on that issue right now and will report on that later in the week. My working hypothesis is that these institutions are focused on teaching the logic behind accounting but not how it must be applied in today's real world.

3) Do auditors believe they fulfill a role in protecting the public interest? This one's tough. Auditor's evaluate the methods used to prepare and report financial results. They may discover fraud but they would argue that fraud detection is an ancillary, not primary, benefit of their work. Traditionally, auditors look at prior economic events, ensure they are recorded correctly and publish the results. They are not the bookkeeping police. Their job is not to protect and defend ( a nod to the folks in blue) but to report. While that's been the case, it may need to evolve must as police have had to become savvy about combating terrorism and other new threats.

4) Should any auditor accept work with companies that use SPEs? My short answer is no unless the SPE accounts for an immaterial portion of total revenues/costs. The accounting profession lacks real standards for reporting the true risk and exposure behind SPEs. When I read a recent Bear Stern's annual report, the number of SPEs and the amounts of monies associated with each made it impossible for me (and the average investor) to assess the true degree of risk associated with Bear Stearns stock. Worse, the lack of commentary regarding the insurance behind the sub-prime instruments acted as an additional layer of obscurity for investors. Without new accounting reports that provide new levels of transparency into these dealings, the auditor statement on these annual reports is worthless in my opinion.

5) Should Sarbanes-Oxley be repealed? Absolutely. This legislation was intended to inspire shareholder confidence but the documentation of processes didn't produce better accounting results. It did produce obscene profits for Accounting firms. It is unconscionable to allow these firms to continue to profit from legislation that does not help the public good.

6) How innovative should accounting become? Much More! There's so much technology today that operates inside the firewall,in the wide-open Internet and in external databases. New solutions could be built that bring numerous outside data and perspectives to bear. New solutions could offer always-on audit and risk assessment capabilities. Early users of accounting services were grateful for the innovations of Luca Pacioli but could the same be said today? Innovation must occur or the industry will further lapse into irrelevance.

7) Do accountants offer a service, a solution or are part of a profession? This one's a loaded question. Today, I'd say they are service providers that provide a narrowly defined, mostly irrelevant and low-value solution. I would not classify it as a profession anymore. Professionals put public interests first. Professionals have a code of conduct that makes them divorce themselves of unethical clients or illegal or unethical practices. They do not compromise on materials of professional integrity. I cannot see how an auditor can sign off on financial statements when the presence of SPEs makes it impossible to assess the true business and financial risks a client really faces.   

This is an industry in trouble. It needs strong leadership, innovation and change. Will it happen in time?

Destination Wedding? No - Destination Surgery!

                      Surgery - the Emerging Outsourcing Frontier

Next time you need that gall bladder surgery, coronary bypass or other health procedure, your insurer may ply you with financial incentives to get you to have the operation outside of the United States. For example, a heart bypass costs between $10,000 - 18,500 if you have it in India, Thailand or Singapore. Stateside, it will set you back $130,000.

As employers re-negotiate health care benefits packages, some may insist on medical travel unless you want to pay some steeper deductibles or plan costs. In this situation, outsourcing is triggering the work (i.e., the patients) to come to the offshore firm.

This trend may take some time to gain material uptake in the marketplace. Employers with unionized work forces are already spooked about offshore job losses and they will fight these moves. The fact that U.S. patients might lose the right to sue for medical malpractice when using certain overseas physicians or facilities could be another deal breaker.

That said, quality of care in the few facilities offering this is rated well for now and this will need to be closely monitored and adhered to if these sorts of programs are to take off.

Will we see either Hillary Clinton, Barack Obama or John McCain recommend this during their election campaigning? Doubtful.

For more info, see: The Economist, March 24, 2008, "Outsourcing the Patients".

EDS - Overtime Dispute

                                Money Will Settle This

Last month, six former/current EDS employees filed a class-action lawsuit seeking overtime pay (see: http://www.examiner.com/a-1224633~EDS_technical_service_workers_sue_for_overtime_pay.html ). This type of suit occurs frequently and hinges on whether or not specific workers were correctly or incorrectly identified as 'exempt' under Fair Labor Standards Act (FSLA) regulations.

Not surprisingly, specialized websites have sprung up to identify other potential claimants/plaintiffs (see: http://www.edsovertime.com/ ). CRN, Computer Reseller News, has also covered this story.

FSLA suits are usually solved with money. Some goes to the litigants and some goes to lawyers. If found in violation of FSLA regulations, the offending employer makes adjustments to their payroll system going forward, recalculates owed back pay and makes restitution.

Is this a BIG story? Probably not. It's interesting and very solvable. It's only scandalous if long-term patterns of deceit/fraud are uncovered. If it's a legitimate difference of opinion in interpreting regulations, fraud is much harder to prove. Without fraud, the fines will likely be scant. 

M&A in the Services Sector

           Government Sector Deal Volume - Whole Lotta Dealin' Going On

Check out these two links:

http://www.washingtontechnology.com/print/23_03/32312-1.html

http://www.washingtontechnology.com/mergers_acquisitions/2007/

The first is a good article discussing the consolidation occurring in the government systems integration sector. The second is a list of deals that transpired in 2007. It's a good list and one that helps put the services M&A activity in perspective.

There's something structural occurring in this space and it appears that consolidation is being undertaken to:

• create additional scale
• create marketing and operational synergies
• broaden expertise in more service areas

There's something else happening, too. Government services contractors are now becoming more distinct from their private sector counterparts. In fact, it's getting rarer to find firms that successfully sell and service both spaces or serve both spaces well. Why? Well, the selling effort has always been different between public and private sectors. But now, service firms need distinct and focused offerings just for governmental entities (think of Homeland Security - It has very unique needs, needs a lot of help and it didn't even exist a few years ago). Moreover, given the high development costs of some offerings, government service providers are realizing that they must have scale to keep costs at their lowest possible levels so as to continue to extend their win rate.

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. 

Name Your H-1B Legislation

       When Congress Gets Creative - The Selling of H-1B Legislation

Two new bills are being introduced in Congress to raise the cap on the number of H-1B visas. One would double the number initially and eventually triple the number of visas granted annually. The other takes the limit up to 195,000 in 2009.

Take the H-1B Legislation Naming Game!!!

Can you guess which legislation names are legit and which aren't?

1. The Innovation Employment Act
2. SUSTAIN - Strengthening U.S. Technology and Innovation Now
3. Replacement Work Force
4. Full Employment Act for Outsourcing and Global Competitiveness
5. The North American Job Security and Economic Stimulus Act
6. American Workers are Lazy, Uneducated and Ignorant of Technical Disciplines

The correct answers are the first two although numbers 4 & 5 could also work. The congress persons leading these efforts should be applauded for the creative names they've chosen. You'll notice that the bills are named around innovation as any name that would imply loss of jobs to offshore workers would be death to their political careers.

If you'd like to learn more about these bills (e.g., exactly who is sponsoring them and where they are from), please read: http://www.eweek.com/c/a/Careers/Bills-Would-Double-and-Triple-H1B-Cap/ .

   

Let The Fighting Begin - H1B Issue Goes to Washington

                The Best Reading on H-1B: Issues, Testimony, Fraud....

                        Can't We Make a Hit TV Show From This?

Ever get the feeling that someone's making money on those H-1B visas you read about? Check out U.S. Senator Chuck Grassley's letter to the Bush administration re: H-1B visa abuses: http://grassley.senate.gov/public/index.cfm?FuseAction=PressReleases.Detail&PressRelease_id=9af53fa4-b99b-5638-8db2-5021e681c258&Month=3&Year=2008 There's some really juicy stuff in this. It discusses the blatantly illegal job advertisements here in the U.S. where advertisers are only looking for holders of H-1B visas. It details how visa factories are being established to create false employer fronts within the U.S. There's the story of an Iowa businessman getting harangued by an offshore firm with all of these potential visa holders on the bench. The fact that Homeland Security is being alerted to these abuses suggests something is really rotten here. Great reading - really.

Computerworld expands on the Senator's letter in this story: http://www.computerworld.com/action/article.do?command=viewArticleBasic&articleId=9067738&intsrc=hm_list . Like the above, it's a great read, too.

We also have Network World chiming in with their piece: http://www.networkworld.com/news/2008/031208-h1b.html.

Bill Gates, of Microsoft fame, testified before Congress and a synopsis of his remarks can be found here: http://www.networkworld.com/news/2008/031208-gates-immigration-reform.html

All this comes at a time when the U.S. government is being asked to raise the limits on H-1B visas from 65,000 to 110,000/year.

Here are the questions U.S. policy makers must address pronto:

• Does bringing in more non-US workers actually motivate US students to pursue technical degrees or does it achieve the opposite effect?
• The H-1B program was intended to bring in people with unique skills and talent. How do green, low-level tech coders meet that standard? What aren't more PhDs being granted this visa?
• Why are large tech outsourcers allowed to hog the number of available visas? Should U.S. based tech companies get an equal or better opportunity to import scarce, unique talent?
• Why are students at U.S. colleges electing not to pursue careers in technical areas? Is it because of bad employer behavior? Is it because these positions are vulnerable to outsourcing? Is it because potential employers send mixed signals to colleges, employees and job seekers? Or, is it that U.S. college students can't be bothered with these degrees? What is the real root cause?
• Is the L-1 visa program as messed up as the H-1B? Should both be addressed?

Approving or disallowing the increase in visa permits is not the issue. Congress must address bigger concerns (e.g., national security) and discover the answers (and appropriate remedies) to the matters above and more.

Calling all Lawyers... The Bear Stearns Collapse

                        Another Enron on the Way?

Today's announcement that Bear Stearns will be acquired by JP Morgan/Chase is stunning on many levels. The most stunning aspect, though, may be the token price paid for the company: $2/share or $236 million.

That price is shocking simply because the company's stock closed at $30/share less than 72 hours earlier. That means shareholders have seen the market value of the company fall from a tad over $4 billion Friday to fifteen times less by Sunday.

Shareholder litigants are going to be talking about this one tonight and tomorrow. Let's recap the fall of Bear Stearns stock price and market value the last year:

• Stock price last year: $159/share - market cap: $18.76 billion
• Stock price last week: $69.75/share - market cap: $8.23 billion
• Stock price Friday: $30/share - market cap: $4.04 billion
• Acquisition price Sunday: $2/share - market cap: $236 million

When companies fail this spectacularly, management usually is culpable for a big piece of the precipitous stock drop. Enron immediately comes to mind.

The Bear Stearns situation is tied to the sub-prime situation and, like Enron and its special purpose entities, the role of Bear and its executives in this market problem will need to be examined further.

Lawyers, forensic accountants, forensic IT people and more will doubtlessly benefit from this failure but the losers will be Bear Stearns management and employees, the US Government, taxpayers and others. Corporate America could also be a big loser if this fiasco triggers another wave of governance legislation like the way Sarbanes-Oxley was spawned out of the Enron collapse at the beginning of this decade.

Are criminal indictments in the future?

(for more info, see: http://edition.cnn.com/2008/BUSINESS/03/16/stearns.morgan/?iref=mpstoryview )