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A Tool to Improve Audits

              Comparing What Execs Say to What They Report

CFO magazine reported on the efforts of an associate professor at Virginia Tech and others to develop a tool to help steer auditors to look for potential fraudulent activity. In essence, this tools compares what executives say publicly and where auditors ought to look for potential fraud.

In a test using a blind pool of business data/results, the database tool identified within a 60-80% accuracy those firms that had committed fraud.

A longer story about this technology can be found on this Virginia Tech website.

Directionally, this is the sort of technology that the audit industry sorely needs and rarely funds. My hat's off to Greg Jenkins and Patrick Fan for devising this.

Oh, the Things Auditors Do....

    Take a Tour on the Public Company Accounting Oversight Board Site

The PCAOB was setup by the US Congress as part of a number of post-Enron, SarbOx changes. The website, www.pcaobus.org is interesting although the age of some of the documents on the site would leave one to believe that:

• it takes years for this august group to make a decision
• change is really slow in the world of auditing

There are some nuggets in there, though. If you'd like to read about a Deloitte case, it's there. There are disapproval notices (although the most recent is 2005). One disappointing section of the site is the News/Events page. Most of the announcements deal with speeches someone is giving or accounting pronouncements.

For a group that was spawned from the tumult of Enron, there seems little relationship between its origins, it's raison d’être, and what they are doing. I'm still not sure how pronouncements and board or staff appointments are preventing more Bear Stearn collapses. In fact, I didn't immediately see anything on the site that addressed SPEs (special purpose entities) or CDOs or other instruments found in the Enron and/or Bear collapses.

Is this group effective? I'm not convinced. Comments?

see also Forbes 4/21/2008 "Auditing the Auditors".

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. 

Mark-to-Market Accounting

           "It is the worst kind of accounting, except for all of the others"

Accounting rules regarding the valuation of assets, including notes, receivables, securities, real estate and more vary from country to country. Thousands of businesses this year will writing down the value of many assets simply because the fair market value of these is plummeting. Owners of mortgages and real estate are seeing real estate prices plummet as aftereffects of sub-prime meltdowns and softening economy. Balance sheets will suffer and so, too, will the stock prices of those companies holding assets that are getting marked down to new, low market prices.

Re-stating the value of assets is prudent as it reflects the current, liquidated value of a firm. However, some of this is getting less relevant as time goes on. Specifically, more and more of a businesses value is determined by its intangible assets. In an era where firms don't have to own their manufacturing plants and can outsource their front office, back office, distribution and more, how can an accountant value intangible assets like brand, mind-share, innovation capability and more? How much is Steve Jobs worth to Apple's share price? Can you find the asset called Steve on the Apple financial statements? No.

Accounting has a lot of work to do as a profession and the glacial pace of innovation in that sector is inappropriate today - inappropriate in a world that moves at the speed of electrons not dinosaurs. I wish I could time travel just to bring Luca Pacioli to the modern world. I doubt he'd find today's accounting practices relevant for today's businesses. Sadly, today's accounting standards are all we have.

(title quote from Economist March 8, 2008)

Great Insight into Fraud Finders

Who are the Whistle Blowers

(see: http://faculty.chicagogsb.edu/luigi.zingales/research/PSpapers/whistle.pdf )

(also thanks to Strategy + Business magazine for alerting us to this research)

Who finds the fraud in businesses today? The SEC? Not if you read the research by Alexander Dyck, Luigi Zingales and Adair Morse. They looked at 230 cases of corporate fraud involving more that $750 million in assets. Their report is a great read and it covers a number of issues, findings and recommendations in its very accessible report body (approx. 44 pages). I highly recommend this as a must read.

Here’s a great quote from this report:

“We find that no specific actor dominates the revelation of fraud. Even using the

most comprehensive and generous interpretation, shortsellers and equity holders revealed the fraud in only 9 percent of the cases. Financial analysts and auditors do a little better (each accounting for 14 percent of the cases), but they hardly dominate the scene. The Securities and Exchange Commission (SEC) accounts for only 6 percent of detected frauds by external actors. More surprising is the key role played by actors who lack a direct role in investment markets, such as the the (sic) media (14 percent), non-financial market regulators (16 percent), and employees (19 percent).

As interesting as who detects corporate fraud are who did not. Stock exchange

regulators, commercial banks, and underwriters are notable for their complete absence. Also, private security litigation plays a minimal role (less than 2 percent) in the detection of fraud. This does not mean that it is useless to prevent fraud, since it could be the mechanism through which people committing fraud are forced to pay for their mistakes. But it does suggest that this mechanism cannot work alone. It needs another (vast) set of institutions to help bring fraud to light.”

Also interesting was the time required for different groups to detect the fraud.  Plaintiff lawyers took 31.4 months while the SEC took 21.2 months, employees took 20.9 months and financial analysts/short sellers only 9.1 months.

Information like this point out that the current wave of GRC (governance, regulation and compliance) technology and legislation is either unnecessary or may not produce the desired effect governments are hoping for. Certainly, governments may claim that SarbOx and its relatives are needed to give the SEC a better success rate but the fact that so many other constituencies are identifying fraud (and faster, too) than the SEC may suggest that better answers lie elsewhere.

I’d like to see more automation re: auditing and how major auditing firms re-invent their businesses. We should expect auditors to have real-time access into client information systems and using tools that automatically highlight questionable transactions for immediate review. The idea of an annual audit seems so out of place in this modern age. An annual review of the books may have made sense in Luca Pacioli’s time (i.e., 1493 AD) but not now with the technology, analytics and other capabilities available to auditors.