Constant's pations

If it's more than 30 minutes old, it's not news. It's a blog.

Tuesday, September 07, 2004

Audit liability cap rejected, despite auditors' threats

That's right. The auditors had threatened the clients with, "We won't do our jobs unless you ensure we are not held 100% responsible for our failures."

Story; and cap request rejected.

Funny how the auditors forget who they work for.

The last thing they want to do is threaten to "walk unless...". That's not a negotiation. Those auditors need to be called on their bluff: "Fine, we'll find someone else to earn lots of money..."

Auditing is a cost of doing business

The auditors in the UK want to have their litigation risk capped. That sounds reasonable if you're an auditor. Talk to a shareholder that relies on that "independent" audit before evaluating the financial figures, and they might have another view.

IF the auditors "don't want to back their words they make about the quality of the financial statements," then why should we believe the auditor statements really mean anything?

The auditor "only really is willing to stand by their word, if they're not held liable if their word is not worth anything.

Congratulations. The auditors have proven their worth: Nothing. In fact, the auditors have so little to stand on, they don't even bother discussing their problem and asking for help. They simply threaten.

Let's review what auditors are supposed to do. Auditors are the ones that the corporate board, management and stockholders hire to "check things out." This means "making sure that there's a close relationship between "what the auditor finds" and "what management is saying."

The auditor isn't saying "things are going well," or "this is a good investment." They merely make an opinion on the quality of the financial information; the board, management, and stockholders then get to make a decision on "what do we do, if anything."

Auditors aren't independent if they threaten

The auditors main purpose in life is to be independent. And their role is to do what must be done to evaluate the numbers. Auditors get paid for providing that independent view.

The auditors are asked to, if necessary, "increase audit scope" if they find problems. The problems don't necessarily have to do with numbers. Sometimes auditors will get a number of "non-financial indicators" that suggest to the auditors that they need to spend more time, or dig more.

One things auditors do is something called sampling. This is like polling before an election. The auditors don't look at every account. The just take a random sample of accounts, evaluate those accounts, and then based on that sample, make a prediction about the whole state of the financial information.

Here's the trick. Auditors are also supposed to evaluate non-financial indicators [management turnover, complaints about unusual transactions, and other things that are not necessarily related to "problems with the numbers themselves. Rather these "non-financial indicators" are a measure of risk; the auditor is paid to evaluate these risks, and appropriately increase the scope of the audit.

When we say "increase audit scope" this doesn't necessarily mean the same thing to all people. Some audit-clients require simply more time; others require additional expertise on the audit team; other clients simply require a larger number of accounts to be reviewed.

The auditors when they are facing a margin squeeze, and they have the perception that the "economy is going to turn around," would like to hold onto "good clients." This, in layman's terms means, even though the economy might be tanking, and the customer "can't afford to pay the full audit fee," the auditor may forego reporting actual costs, and simply take a wash or a loss on the audit engagement. The goal is to stick around, and then make up the losses later.

Here's the problem an auditor runs into. There are times when they've got such a "good client," that they are blind to the economic conditions. This means that they simply continue to inadequately scope the audit despite higher audit risks, undercharge the company for the audit, and essentially make a statement about the clients numbers without adequately scoping the audit per the "non-financial risk indicators."

This is not a problem if the economy turns around. It is a problem when a company like Enron is not only losing money, but is actually paying the auditor large consulting fees to "teach the company" how to hide money in favorable tax havens. Andersen got bit.

Which bring us to the UK and the present stand off between the auditors and the UK regulatory board. The auditors know they have a problem. There are some potentially huge financial damage awards for stockholders who failed to liquidate their holdings before the fraud surfaced.

When the stock tanks and there is fraud, the company and auditor are jointly liable for the losses to investors. This assumes that the losses are proven in court as being related to fraud.

The auditors can get hit with a large bill when the audit client [the company whose stock actually tanked] runs out of money, or goes bankrupt. In short, the very company that is most likely to commit fraud is also the most likely to go bankrupt.

These risks are known to the auditor before they sign their contract to conduct an agreement. Thus, what is actually happening is the auditors [now that the sham-economy is failing to recovery, and more fraud is occurring] are trying to get out of their full liability.

Questionable contract compliance

Hold on. Let's consider something called an "agreement" or a "contract." This means that one party bargains with another to get something in return; in this case, the auditor said to the corporate boards, "We will audit your numbers, and in return we would like to be paid; and we would like to command a high fee because our statement means something."

The corporate board says, "Gosh, what a great deal." They pay the bill, and the auditor "stands by the numbers." The moment the auditor makes a statement about the quality of those numbers, they become associated with them.

If the numbers are really bad [meaning: The numbers that are reported are not really what is going on], then the auditor may say, "We withdraw" and make no statement on the quality of the numbers.

If the auditors adequately detect the chance of fraud, and report this information and disclose a reasonable assessment, there is no liability. They have done their job.

The auditor always has this option. In fact, if there is a potential disaster about to explode [in terms of really bad financial numbers, and massive stock losses], the auditor's senior partners [who have their personal assets on the line through joint partnerships] are putting the interests of the auditor before the market. IN short, the auditors are saying, "even if we told the truth, the potential disaster is something we don't want to be associated with.

Again, the auditors always have this option: Withdraw, walk away, and say nothing.

But this is not what the auditors in the UK have done. Rather, they've collected high fees, made attestations about the quality of the numbers, and then "when the news is bad," rather than withdrawing they go to the regulators and say, "Even though we are paid alot of money to stand by our numbers, we did not really want to do that."

I give up. If the auditors can "out of the blue" announce "we do not want to really stand by our numbers or our statements," what good is it to have an audit?

The answer is, "You can't change horses midstream." Which is exactly what the auditors are proposing to do. All these years the auditors have been paid high fees to audit; and in exchange they get to throw around their name and say, "Look, we command high fees because our word means something."

Now that the markets are not cooperating, the auditors want their liability capped.

This does nothing for the corporate boards or the stockholders. There were contracts signed; and those statements were supposed to be backed by their word.

Who's really standing by the clients?

Today, we realize that when times are tough, you can't rely on the auditors. Rather, they will without warning propose to "no longer take the liability" for something that they had previously been paid to do.

Remember, the auditors have liability insurance. This means that there is insurance if the auditors make a mistake.

Today, we are asked to believe "despite their fees, and liability insurance," the auditors do not want to stand by their word in cases where there is alot of fraud that the auditor was paid to detect, but failed to detect.

If the auditors want their liability capped, then we might as well return to the days of "buyer beware." This was the day of "you may not be able to really on the numbers."

If that's the kind of gambling casino you want to expose your cash to, feel free to go to Vegas. But if you want to expose your capital to a financial reporting and regulatory system that ensure the numbers mean something, and that the auditors statements on those numbers mean something, and that those who fail to do their job are held accountable, then consider exposing your cash to the UK.

However, if the auditors get their way and have the liability capped, world investors should know, "If you expose your money to UK capital markets, you may not know whether the numbers are reliable. IF the auditor really goofs up, they know they are not held 100& liable for all losses.

Rather, the auditor knows they can escape accountability for the full damages caused by their failure to adequately conduct an audit.

This is the regulatory regime the auditors in the UK want: Get paid high fees, but not be held 100% liable for the damages they've caused. That is not auditing. That is called blackmail.

The auditors in the UK who have threatened "cap our liability or we won't audit" need to be shown the door. They have shown that they've forgotten why they are there. They are there to work for the public, not themselves; and the auditors are there to evaluate the numbers and stand by their words, not attempt to get out of the responsibility for their otherwise failed audits.

Let it be clear. The auditors are willing to put their own interests before the clients, the people who pay the bills. Even if the UK "cap proposal is refused," never forget: The auditors were willing to threaten the client in order to not be held accountable for their failures.

You have been warned. The auditors have shown themselves to be arrogant, and it is time the corporate boards fire these auditors. They are forgetting "whose capital this is." They incorrectly believe that the money is theirs, not the stockholders.

The auditors got the needed wake-up call.

In the meantime, it is time to only hire auditors who are willing to stand by their word. If they want to change the rules, it's time to change auditors. If no auditors want to audit the books, even though they have the opportunity to correctly report the truth however bad, then the UK has a much larger problem that simply whether or not the auditors liabilities are capped.

The auditors had to blink, but buyer beware!