Oversight board investigates lack of warnings by auditors before financial crisis

March 16, 2011

The financial crisis has left some observers wondering why audit firms did not prevent or warn investors about problems that ultimately had a devastating effect on the U.S. economy.

Now the nation’s top audit cop is asking the same question.

The Public Company Accounting Oversight Board is conducting investigations that may lead to disciplinary action against audit firms or individual auditors, the board’s chairman, James R. Doty said in a statement he prepared for a meeting Wednesday.

“In several cases — including audits involving substantial financial institutions — PCAOB inspection teams identified what they determined to be audit failures,” Doty said.

The oversight board’s investigations are unlikely to shed light on the issue anytime soon. Under federal law, unless the board gets a waiver from the subject of the investigation, it must keep disciplinary proceedings confidential until they are concluded.

“This will take a long time,” Doty said.

Revelations of systemic problems in the mortgage industry, including shoddy documentation of loans, have raised additional questions about auditors.

Under a post-Enron law, auditors have been responsible for auditing not just a company’s financial statements but also its internal controls.

In December, New York’s attorney general filed a lawsuit against Ernst & Young, alleging that it helped Lehman Brothers hide billions of dollars of liabilities by temporarily removing them from its books at the end of fiscal quarters. The “Repo 105” transactions, which came to light after Lehman collapsed at the height of the financial crisis in 2008, were explicitly approved by Ernst & Young, alleged Andrew Cuomo, who was then attorney general and is now governor of New York.

Ernst & Young vowed to fight the lawsuit, saying, “Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry.”

While its own investigations play out, the oversight board is studying how to make audits more informative for investors.

In general, after an annual audit, the auditors write a boilerplate letter essentially saying whether the company passed or failed. The vast majority of companies pass. Some investors are urging the board to require auditors to describe potential trouble spots in a company’s accounting.

The oversight board discussed the possibilities in a meeting with an outside advisory group Wednesday.

“Investors clearly want more from the audit report,” Doty said in his prepared statement.

The oversight board is a nonprofit group created by Congress in 2002 in the aftermath of accounting scandals at Enron, WorldCom and other big companies. Its job is to write rules for audits and to police audit firms.

Outside advisers to the board conducted an informal survey of professional investors and others and found that many consider the auditors’ letters virtually useless.

Almost half — 45 percent — of the people who responded said the audit report “does not provide valuable information that is integral to understanding financial statements.” Only 23 percent said the reports provide valuable information.

“When 90 to 95 percent of companies get the same exact report, the information content is minimal,” Joseph Carcello, a University of Tennessee accounting professor and an adviser to the oversight board, said in an interview.

Corporate financial statements often involve estimates, which can give management leeway in how much profit or loss they report. Almost four out of five people who responded to the survey said they wanted more information from auditors about the quality of those estimates.

Companies and auditors now allow some errors to go uncorrected on the grounds that they are not “material,” or significant enough to require disclosure. For example, in the 1990s, years before Enron collapsed, the Arthur Andersen audit firm initially challenged accounting that added $51 million to one year of Enron income. Andersen decided to let those problems go uncorrected.

Most of the people surveyed said they wanted more information about how auditors determine what is material.

To establish greater accountability, some investors are proposing that the individual auditors in charge of audits should be required to sign reports. Those audit reports are typically signed by the firm in its own name

Spokesmen for the four major accounting firms did not immediately respond to requests for comment.

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