Finger of blame points at auditing firms

By Ian Fraser

Sunday Herald

October 12th, 2008

Accountants of failed banks missed ‘red flags’. By Ian Fraser

THE FINGER of blame for the crisis that has crippled global financial markets in recent days has been pointed in many directions. Over the past few months, regulators, central banks, banks, ratings agencies and even consumers themselves have all taken the rap for inflating the credit bubble whose bursting last year is now causing unprecedented fall-out for financial institutions, governments and economies worldwide.

However, last week a new scapegoat emerged: the accountants, who have been responsible for signing off the accounts of many of the world’s most dangerously exposed financial institutions, are coming under scrutiny.

Prem Sikka, professor of accounting at Essex Business School, Essex University, believes that audit firms have failed to spot any of the red flags as the credit bubble stretched to bursting point. “The auditing industry likes to compare audits to a health check,” says Sikka. “Many of the distressed companies have been on a diet of toxic debts, off-balance-sheet accounting, dubious asset values and questionable business models. Yet auditors did not notice any of the red flags.”
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Ernst & Young is fortunate that it is not really considered big enough to audit international banks (although it did, of course, audit Lehman Brothers). However, the other three big firms — Deloitte & Touche, KPMG and PwC — have all been responsible for auditing several of the banks and financial firms that got themselves into difficulties.

In most cases the accountancy firms also provided non-audit services to their financial sector clients creating scope for conflict of interest. Last year, Deloitte & Touche earned fees of £31.2 million from its client Royal Bank of Scotland (of which only £17m, or 54%, was for at the audit of the Edinburgh-based bank). Deloitte also audited Washington Mutual, which was closed by the US government and sold to JP Morgan.

KPMG was last year paid a total of £11.4m for providing accountancy and consultancy services to HBOS. KPMG also provides audit services to other leading financial sector clients including Bradford & Bingley (nationalised by the UK government), Fortis (bailed out by the Benelux governments), and Wachovia (rescued by Wells Fargo).

PricewaterhouseCoopers, the auditor of failed banks BCCI and Barings during the 1990s, has been criticised for its role in auditing Northern Rock. PwC also counts the collapsed Icelandic bank Glitnir and Belgo-French lender Dexia among its audit clients. It also jointly audits Fortis. On Friday, they adopted new guidance on how banks’ assets should be valued in a distressed market. The Financial Accounting Standards Board (FASB) said it would usher in greater flexibility in the application of “fair value” accounting where there is no market for a given security.

Fair value accounting, sometimes known as “mark-to-market” accounting, requires banks to value their assets at current market prices. However, banks – with the backing of congressional Republicans – have been pushing for the Securities & Exchange Commission to drop this requirement, in the knowledge such a move would permit them to strengthen their balance sheets.

The $700 billion bail-out bill, introduced by Treasury secretary Hank Paulson, and enacted last week, affirms the SEC’s authority to suspend the “mark-to-market” rules and encourages the agency to look into the rule’s effect on US bank failures this year. Under the change, where there is no active market for a security, companies would be allowed to use managers’ estimates of their value, taking into account expected future cash flows and risk discount rates.

FASB chairman Robert Herz said:

“Often, when there is a dearth of relevant observable data, more analysis and some judgment needs to come into play in those situations.”

But critics fear that suspending the fair value rule would undermine financial statements and encourage the sort of questionable accounting practices that defined the Enron era of corporate scandals earlier this decade.

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