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Bank Debacles Drive Europe to Raise the Bar on Audits

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When Michel Barnier of the European Commission singled out auditors for enhanced scrutiny this week, he was reacting to anger, in Europe at least, over the "no bark, no bite" behavior of accounting "watchdogs" before, during, and after the financial crisis.

Barnier, the EC's internal markets commissioner, proposed a wide range of new rules focused primarily on the largest audit firms. The recommendations are in draft form. A final version goes to the EC for debate in November. They include prohibiting audit firms from providing consulting and advisory services to audit clients — bookkeeping, tax advice, actuarial and valuation services, risk management, and legal services.

If some of that sounds familiar, it’s because the proposed service restrictions are close to those introduced by the Sarbanes-Oxley Law of 2002.

The most dramatic reforms go further and could require audit-only firms, auditor rotation every nine years, and dual audits, as well as enhanced auditor reporting to shareholders.

(However Barnier's recommendations fell short of Sarbanes-Oxley on one count. They do not restrict audit firms from providing systems development and implementation services and internal audit to their audit clients.)

The clamor for accountability from the auditors for financial crisis failures and losses has been much louder, much stronger, and going on much longer in the U.K. and Europe, than in the United States. Barnier's most dramatic proposals are viewed by most commenters as a reaction to the bank failures. "Auditors play an essential role in financial markets: financial actors need to be able to trust their statements," Barnier told the Financial Times. "There are weaknesses in the way the audit sector works today. The crisis highlighted them."

There's is a concern on both sides of the Atlantic over long-standing auditor relationships.

The average auditor tenure for the largest 100 U.S. companies by market cap is 28 years. The U.S. accounting regulator, the PCAOB, highlighted the auditor tenure trap in its recent Concept Release on Auditor Independence and Auditor Rotation. According to The Independent, quoting a recent House of Lords report, only one of the FTSE 100 index's members uses a non-Big Four firm and the average relationship lasts 48 years. Some of the U.S. bailout recipients — General Motors, AIG, Goldman Sachs, Citigroup — and crisis failure Lehman had as long or longer relationships with their auditors.

The risk to capital markets posed by out-of-control, systemically important, global banks is not ancient history. UBS — which is audited by Ernst & Young like Lehman was - now has a "rogue" trader scandal, as well as ongoing troubles with the IRS over tax shelters. The bank recognized huge losses during the financial crisis as a result of its forays into subprime mortgages. As attorney and blogger Jim Peterson points out, UBS would have been better served by, "re-directing some portion of that audit fee to an engagement to conduct a precise and effectively directed, root-and-branch scrutiny of the condition of the controls at the sections of your bank having potential to inflict multi-billion dollar harm."

The most recent lawsuit against Bank of America, over the Merrill acquisition, claims a disturbing lack of financial disclosure controls. It's taken a while to be filed but piles onto several lawsuits claiming poor controls over reserves for loan losses and lack of disclosure of litigation related to loan repurchases.

Where were the Bank of America auditors — PricewaterhouseCoopers, auditor also of AIG and Goldman Sachs — when the 10-Qs and 10-Ks that allegedly lack sufficient reserves and disclosures were filed? Is there something more they could have done to warn shareholders that the bank may have been scrimping on disclosures to shareholders or leaving out disclosures altogether?

The PCAOB agrees that there's "generalized investor dissatisfaction with the pass-fail model, and generalized frustration with auditors who had issued unqualified opinions on the financial statements of banks that later failed." They've issued a concept release for revisions to the auditor's report but it's been met, like the European Commission's reform proposals, with disdain by the audit firms and their "clients," company executives.

One comment letter to the concept release quoted by Peterson comes from the Center for Capital Markets, an initiative of the U.S. Chamber of Commerce. The letter notes "the PCAOB's intent to retain the current ('pass/fail') form of the auditor's report," and reminds them there's "overwhelming support from all stakeholder groups for retaining this long-standing approach to auditor reporting."

It may be time to ask why. Regulators should focus on the product first — the audit and audit report itself — and then on the mechanics of its delivery, especially for systemically important organizations like global banks.

Francine McKenna writes the blog re: The Auditors, about the Big Four accounting firms. She worked in consulting, professional services, accounting and financial management for more than 25 years.

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Comments (2)
The problem is not with the auditors. It is with generally accepted accounting principles (GAAP) that give banks the ability to delay reporting bad news until it is too late. Analysts and regulators are unable to decipher GAAP numbers to reach a reasonably informed opinion on a timely basis.

David Mosso
Posted by David Mosso | Monday, October 03 2011 at 3:18PM ET
@David Mosso

Thanks for your comment. I agree GAAP can be a problem. However, it taketh away as well as gives. When things started going south, GAAP required assets to be written down, especially on the trading side. So what did banks do? Claimed economic necessity and had the rules changed. http://www.washingtonpost.com/wp-dyn/content/article/2009/04/02/AR2009040201264.html

The disclosure rules for litigation contingencies are woefully inadequate. And look at goodwill. Bank of America, for example, is holding onto a valuation for goodwill related to its disastrous acquisitions that exceeds its market capitalization.

Where are the auditors to inflict some discipline and force those disclosures and write downs?

Francine McKenna
Posted by Francine McKenna | Tuesday, October 04 2011 at 12:53PM ET
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