Auditors Failed To Enforce Accounting Standards--PCAOB Report

The Public Company Accounting Oversight Board released a report today which reveals that auditors failed to make companies comply with GAAP in key areas such as mark to market accounting and off-balance sheet transactions.  The PCAOB observed individual audits at major financial institutions during the 2007-2009 period. Here are the major findings from the report:
PCAOB inspectors identified instances where auditors appeared not to have complied with PCAOB auditing standards in connection with audit areas that were significantly affected by the economic crisis, such as fair value measurements, impairment of goodwill, indefinite-lived intangible assets, and other long-lived assets, allowance for loan losses, off-balance-sheet structures, revenue recognition, inventory, and income taxes.

Firms have made efforts to respond to the increased risks stemming from the economic crisis. The deficiencies identified by inspectors in their reviews of issuer audits suggest that firms should continue to focus on making improvements to their quality control systems.
One of the major issues of contention, the report states was fair value measurements (mark to market accounting). During the financial crisis, there were times when it was hard to get a real market price for a security due to the illiquid nature of some mortgage derivatives. The report states that auditors failed to challenge company models, which produced overly favorable prices for assets that had declined in value. This is an important fact because auditors are not supposed to simply agree a company's internal valuation model. They are supposed to critically evaluate key assumptions used by the models like credit loss and prepayment expectations. The point being that auditors should use their own assumptions to see if a company's valuation model is reasonable or too optimistic. Another failure by auditors was that when they did use competing valuation models, they were usually from third party providers, most likely Mood'y or S&P. The report contends that auditors failed to ask these third party providers what were the key methods and assumptions used in the models. So in effect auditors were simply plugging in models which they failed to properly understand to price obsure assets. The most egregious example cited by the report was that some auditors completely failed to test the valuation of hard to price assets (most likely level 3 assets). They just blindly accepted the company's internal valuation and moved on.

Another major problem found by the PCAOB was how audit firms evaluated off-balance sheet transactions. In particular the report found that auditors did a poor job of making sure they were being accounted for correctly. The idea seemed to be that if an asset was off-balance sheet, then it was out of sight and out of mind. Audit firms should have make a strong attempt to ascertain under what conditions a company's off-balance sheet asset may be forced back on to the balance sheet. Also, did the company make guarantees to third parties to repurchase the asset if credit quality was impaired. Many banks such as Merrill Lynch hid toxic CDO's off balance sheet through special purpose entities who then sold them to outside investors. The key fact was that Merrill Lynch made contractual guarantees to these investors that the firm would buy back the assets if they started to perform poorly. However, Merrill accounted for these assets as if they were not ultimately liable for any losses. It worked for a long time, until they were forced to put them back on the balance sheet. This pretty much amounts to fraud my intentionally misleading stockholders and providing knowingly false information.

The real problem I have is that these same problems are still with us, especially after the FASB relaxed marke to market accounting. The banks continue to lie about there assets, this time with government approval.

Black Swan Insights

Related Articles:
How Merrill Lynch Hid $31 billion In Toxic Assets Off Balance Sheet
Corporate Integrity--- Can you trust company earnings?



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  2. One of the major issues of contention, the report states was fair value measurements (mark to market accounting). During the financial crisis, there were times when it was hard to get a real market price for a security due to the illiquid nature of some mortgage derivatives.