Is an auditor's report worth anything?

Saw a teaser on Yahoo for a WSJ article about a court questioning an auditor’s value, and asking the SEC to weigh in.

One of the country’s most influential courts has asked the nation’s top securities regulator for its views on an uncomfortable subject: whether audit reports by outside accounting firms actually matter.

We have already seen management take control of most Boards, and adopt a dismissive posture toward shareholders. Is this the last page of the book about how “JCs” become completely unaccountable to anyone?

Steve

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We’ve known that audited financial statements are worthless for at least 20 years, since Arthur Andersen took outsized fees to put its imprimatur on Enron’s crooked books.

A guy I went to high school with was a very successful Arthur Andersen partner who went bankrupt even though he had nothing to do with Enron. I guess he wasn’t paying attention during Business Law class when they explained that members of a partnership are responsible for other members’ torts.

Arthur Andersen - Wikipedia

intercst

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And Anderson got beat up for it’s complicity in the conspiracy. Enron’s, and some other honchos, went to prison twenty years ago too. “JCs” no longer go to prison, if they are big enough.

I can’t help but wonder if the case the WSJ is talking about was influenced by a contention, in another recent case, that a disclaimer by the “JC” to not take any financial or auditor statements at face value absolves everyone of accoutability. Is that the future we face as investors? Knowing that management can lie through it’s teeth, fabricate financials, deceive auditors, and not face any accountability for their fraud?

Steve

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That’s Trump’s position in the NY State financial fraud case against his company. And he paid a formerly respected NYU professor (Eli Bartov) $900,000 to testify as an expert witness at trial saying that the disclaimer of “do your own due diligence on our financial statements” obsolves the Trump Organization of any responsibility.

intercst

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If I’m not mistaken, those financial statements were not audited. They were compiled by an accounting firm, but not audited. That’s a very different level of work by the accountants. This is well understood by those who use financial statements daily, but rarely understood at all by anyone else.

Further, fraud by senior management is not something an audit is designed to find. That’s mainly because senior management can cover their fraud by lying to the auditors.

As a one time auditor, I can assure you that when push comes to shove, everyone - including investors and auditors - has to rely on management to provide accurate financial statements. So as an investor, the very first thing you should do is learn about the managers of the company. If the managers are not trustworthy, the financial statements are not trustworthy even if some accounting firm has audited them.

–Peter

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Yes, I was trying to not name a name, as it is the assertion of “JC” unaccountability, to anyone, for anything, that I was addressing.

Auditors must have some forensic ability, otherwise Enron would not have paid them all that money to look the other way, something like $1M/wk in auditing and “consulting” fees. The Enron thing broke after Anderson had already been involved in a fraud at Waste Management.

If that “do your own diligence” is the standard going forward, we investors don’t have a prayer. The things I look at, like shrinking equity, year after year, when the company is reporting profits, can easily be concealed, if management is not held accountable for anything.

Steve

Of course. Auditors have and will continue to uncover fraud.

But the Enron case is not a good example, since the auditors were complicit in Enron’s fraud.

In a typical contract for audit services, the auditors will generally include a phrase something along the lines of:

Our audit is not designed to uncover fraud, but if we find any, we will notify management.

Audits are designed to look for ordinary errors or fairly simple frauds. As soon as two people start colluding to commit fraud, the fraud becomes much harder to uncover. Which isn’t to say it’s impossible - fraud is discovered by auditors all the time. Usually its internal auditors who find that, but sometimes its the outside audit firm.

The key takeaway is that discovering fraud is NOT the primary purpose of a traditional audit of financial statements, it’s a by-product. Audits are really designed to look for errors, not fraud. And in modern financial work, they also take a close look at management’s choices in how to present the financial statements. Things like putting a specific expense in cost of goods sold vs. Administrative expenses. Or showing liabilities as current or long term - or even leaving certain liabilities off the balance sheet altogether as operating leases rather than financing leases.

Audits could be designed to look for fraud, but that would require substantially more work by the auditor, which translates into higher costs to the company for the audit. Most companies are not willing to pay the higher costs for a fraud audit.

Then we get to the issue of fraud by management. Because of upper management’s unique position in a company, they can cover up their fraud pretty effectively and make it difficult to find.

Here’s a simple example based on my own experience. A company purchases items by the container load from overseas. Containers arrive roughly every week or so. The exact contents vary each time, but are generally in a fairly low range of costs - let’s call it from $75k to $100k. Payments are made by wire transfer, identified only by a reference number on the bank statement. Invoices are kept to back up each container purchase. With today’s tools, how hard would it be for a high level manager to create an invoice which looks just like the ones their customer issues? They then instruct the bank to send a wire transfer to the local car dealer to purchase a car for that manager. The manager’s created invoice matches the dollar amount of the wire transfer. Even if you examine the paperwork for this transfer, it’s not going to look out of place.

In a public company, you probably have some separation of duties such that this might be hard to do. But in a privately held company, owner/managers typically have the necessary authority to commit such a fraud. Granted, they may not be duping investors, but they are certainly engaging in fraud.

Or the owner could deposit funds from their personal accounts into the company, calling it sales and thereby increasing the apparent profits from the company. They could then use those financial statements to induce a lender to loan them money.

Fraud by management - whether in a public company or a privately held company - is very hard to uncover, especially if management is at all skilled in covering their tracks.

It’s not the standard, but it is wise advice to investors. Ultimately, investors have to depend on management to provide good financial information to them. So the first thing to do when considering an investment is to look at the integrity of management. If management lacks integrity, you cannot trust what they tell you about the company and you cannot really do your own due diligence. So the investment should be a hard pass.

–Peter

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How do we proles evaluate the integrity of management? I remember Rich McGinn on bubblevision, repeatedly, talking about what great things are coming at Lucent. He sounded really good. Very convincing. And he had no personal history of raping the operations he ran. A few months later, the first earnings warning. Then the crooked accounting came to light. As is the norm these days, McGinn got off scott free.

https://www.edn.com/the-man-who-built-lucent/

https://money.cnn.com/magazines/fortune/fortune_archive/2003/07/07/345538/index.htm

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Hard to do and hard to explain.

The best I can do is say that if you’ve made it through 50 years if life and can’t tell within a few minutes when someone is feeding you a line, you probably will never be able to evaluate the integrity of management.

If that’s the case, stick to index funds or ETFs.

—Peter

AS an ex-auditor I can remember my first week out on audit with KPMG. I was tasked with checking two sales invoices (just two - the total ‘test’ on the sales system of a large company). I found something that wasn’t quite right and was told by the team leader to pick another invoice. I was told ‘don’t look for problems’ which surprised me as I thought that was what I was there for.

The biggest sin as an auditor was going over budget. When I look at audited acounts the only thing I believe is the date that they were signed.

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There is another vote for the auditor’s statement “these statements present an accurate view of the financial position of the company, in all material respects”, isn’t worth the paper it’s written on, presumably because the auditor is more concerned with keeping the company as a well-paying client, than in actually auditing the books?

Steve

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If we are to continue with a system of capitalism in advanced information societies I think we need a strong system of government anti-fraud enforcement combined with legalized totally independent bounty hunter investigators/enforcers.

david fb

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An acquaintance was studying to be a forensic accountant.
Is there such a thing as forensic auditor?

{ Forensic auditing is a specialization within accounting, and most large accounting firms have a forensic auditing department. Forensic audits require accounting and auditing procedures and expert knowledge about the legal framework of such an audit. }

Would short seller hedge funds be forensic auditors in disguise? But for personal use, ala independent bounty hunter types.

Forensic audits are used when there is an expectation that the results will be used in Court.

One would imagine that the SEC supposedly is into forensic auditing.

:disguised_face:. :receipt:
ralph

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I did an analysis of what happened at a small company before I was hired. The owner had been a “hands off” remote supervisor for 2.5 yrs. After losing money all that time, he made (shall we say) major changes…

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Good idea, and as popular with the “JCs” as increasing funding for IRS tax law enforcement.

Steve

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Legalized totally independent bounty hunter investigators/enforcers?

Ouch.

Try to run a business with dozens, or even hundreds, of LTIBHI/Es running around demanding all kinds of details about your business? No thanks.

I was an internal auditor for an international Fortune 500 company for 4 years. Yes, we were always on the lookout for fraud (and occasionally found it). However, the most important service we provided was offering ideas to improve business operations and strengthening internal controls.

Communication with division management was also critical. Often, things that initially look “funny” to an auditor had a rational explanation once you talked to management. Putting something that sounded awful in an audit report that was easily explained away in management’s audit response was a career killer. The job required being inquisitive.

I once did an audit in a French subsidiary. I walked into the CFO’s office and he had a huge sign (in English) that said “Auditors are like people who come in after the battle and bayonet the wounded.” After 2 weeks, we parted on good terms with an audit report filled with recommendations we both agreed to. Communication.

Two weeks was plenty. Can you imagine the poor guy dealing with LTIBHI/Es 52 weeks a year? Especially people who don’t even understand your business model. Good grief.

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Having run a business under fierce continual hostile investigation by the US government, banks, and envious petty competitors for years,

I know of what you speak. Nevertheless, modern corporations are now far too powerful and opaque. The bounty hunter model I have in mind would not have the power to audit, but rather to make bets beyond merely taking on short positions and screeching from the sidelines.

david fb

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The places I worked, management did NOT want any input from the proles. I remember reading about Iacocca talking about when he moved to Chrysler. In spite of the company having been run by accountants since the early 60s, the place had NO internal financial controls. For instance, no-one could tell him what it actually cost to do anything.

The brush-off I always got from upper management was “I know things you don’t”, or “I understand things you don’t”, without ever explaining what those “things” were.

Those bounty hunters would be targeted by management for reprisal, just like internal “whistle blowers” are targeted now, in spite of laws intended to protect them.

Steve

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Exactly. That is why I propose “legalizing” them for public corporations.

Checks and balances are needed anywhere power concentrates to the point of invulnerability.

d fb

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So? That doesn’t mean the “JCs” can’t hire some thug to vandalize your home or car, or intimidate your spouse. In most of the companies I worked at, even asking questions brought reprisal.

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