Toothless watchdogs

The watchdogs auditing our financial institutions haven't been able to stave off the sub-prime crisis. Their failure will hurt millions of people, Prem Sikka

• guardian.co.uk, Thursday 29 November 2007 16.00 GMT

The deepening sub-prime crisis can, like past crises, be laid at the door of opaque accounting practices. The pre-Enron technique of off-balance sheet accounting, which enables companies to understate assets and liability and flatter their profits, is widespread. None of the watchdogs barked.

The corporate dominated Financial Services Authority (FSA) admits that it "did not pay enough attention to the build-up ... of assets off-balance sheet." The Financial Reporting Council (FRC), responsible for good corporate governance and financial reporting, towed a similar line.

The accounts of companies in the sub-prime debacle received a clean bill of health from auditors, who received millions in fees, but within a few short weeks have been exposed as fiction worthy of the Man Booker prize. After Enron, WorldCom, Parmalat, Ahold, Barings and other headline episodes, auditors promised to improve the quality of their work. Have they?

Audit quality cannot be observed by an outsider as audit files are not available to stakeholders. Instead, regulators examine samples of auditor files to assess the quality of audit work. Their notion of quality is compliance with auditing standards, largely shaped by the industry itself. Previous scandals have highlighted the deficiencies of such benchmarks.

The FRC inspects a sample of auditor files to assess the quality of audit work by major UK accounting firms. Without publishing any reports on specific auditing firms, or explaining the current troubles it considered "the quality of auditing in the UK to be fundamentally sound."

In the US, after the Enron and WorldCom scandals, the 2002 Sarbanes Oxley Act led to the creation of the Public Company Accounting Oversight Board (PCAOB). It inspects samples of audit files and publishes extracts from its firm specific reports. These reports do not name the companies who may have received problem audits, but provide some insights into the quality of audit work performed by PricewaterhouseCoopers, Deloitte & Touche, KPMG and Ernst & Young. These firms audit almost all major UK and US banks and claim to have common global standards of auditing.

For 2004, 2005 and 2006, the PCAOB has flagged 65, 47 and 29 problem audits delivered by the big four firms - PricewaterhouseCoopers, KPMG, Deloitte & Touche and Ernst & Young. The initial high numbers may indicate the poor quality of audits at the beginning of the Sarbanes Oxley regime. The numbers game does not tell us anything about the significance of the failures, but each one can have negative consequences for thousands of shareholders, depositors, employers and taxpayers.

The PCAOB's 2006 report on PricewaterhouseCoopers stated that at one company "the firm failed to adequately test mortgage servicing rights and their amortisation ... key inputs to the amortisation calculation, such as the weighted average lives of the underlying loans and the carrying values of the mortgage servicing rights" (from pages 4 and 5 of the report). On another audit, the report stated that the firm failed to "properly design and execute tests of internal controls ... failed to sufficiently test whether revenue was recognised in the proper period ... failed to perform substantive audit procedures on certain critical estimates inherent in the accounting for long-term contracts" (from page 6).

The 2006 report on KPMG stated that the firm "did not perform procedures to test whether certain data the issuer provided to the valuation specialist were complete, accurate, and relevant". On another audit the firm "failed to evaluate whether the issuer's use of hedge accounting for two kinds of forecasted commodity purchases with forward contracts was appropriate. The firm failed to obtain evidence to evaluate management's assertion that the hedges were effective ..." (from page 7). On another audit in some areas the firm failed "to obtain sufficient competent evidential matter to support its audit opinion" (from page 8).

The 2006 report on Deloitte & Touche noted that in one case a company had working capital deficit, two consecutive years of net losses, negative cash flows from operations, and declining gross margins and that there "was no evidence in the audit documentation, and no persuasive other evidence, that, other than through inquiry of the issuer, the Firm, in its evaluation of the issuer's ability to continue as a going concern, had tested significant elements of management's plans for dealing with these conditions, including the forecasted cash flows" (from page 7).

The 2006 report on Ernst & Young reported that in one case the firm failed to identify departures from accounting rules that it should have identified and addressed before issuing its audit report. On another audit it also "failed to test a sufficient portion of supplier rebates receivable, deferred rebate balances, and cost of sales adjustments". The report states that when examining debtors or accounts receivables, the firm "failed to adequately evaluate the extent of the errors" (from page 6).

Of course, the firms contest the PCAOB conclusions. The regulator's benchmarks are also problematical because they only check compliance with the industry's own standards and ignore the impact of organisational culture on the production of audits. For example, it is well documented that to improve their profits firms often reduce the time allocated to complete an audit. One consequence of this is that audit teams ignore awkward looking items and also falsify audit files.

The sub-prime crisis has once again shown that all the watchdogs are too close to the very interests that are to be regulated and are thus unable to deliver. Will any government break this mould?