Moral Hypocrisy: The KPMG / PCAOB Scandal

Auditors aren't that great at detecting fraud and sometimes claim their audits aren't designed to detect it. It looks like they may not be that great at committing it, either (though not for lack of effort).

A Fraudster's Paradise

Sam Antar writes about society's vulnerability to fraud. Here are a few points that stood out to me.

On stiff punishments serving as a deterrent to fraud:

...white-collar criminals don't listen to the rhetoric of prosecutors. No white-collar criminal discovers ethical behavior and stops doing crime because another criminal ends up in prison. While white-collar criminals take precautions against failure, they do not plan on ever ending up in prison.

Sam implies that the expected punishment for fraudsters is no punishment. This suggests a need for stronger prevention and detection mechanisms. How about auditors?

Traditional financial statement audits of public and private companies are not designed to find fraud. What accounting firms call an “audit” of financial reports is really a compliance review designed to find unintentional material errors in financial reports by examining a limited sample of transactions.

In discussions I've had with auditors, I get the sense that most would like to do more to focus on fraud, but they feel like such a focus would be too expensive and would essentially price them out of the market. While I'm not completely satisfied with that explanation (e.g., firms could, at low cost, use computerized forensic tools to search for red flags), it suggests a need for either regulatory changes that require auditors to focus more on fraud or increased demand by investors for audits that specifically focus more on fraud. The latter is unlikely to occur as long as most investors continue to believe that audits are focused primarily on fraud.

In fairness to auditors, Sam's point about deficiencies identified via PCAOB inspections omits the fact that the PCAOB does not inspect audits randomly, but instead focuses primarily on the audits it believes have the highest risk of deficiencies. This means that even though 49% of E&Y's inspected audits had deficiencies, we would expect the actual rate at which deficiencies occur to be substantially lower. Even that lower overall deficiency rate may not be that informative about how effectively auditors conduct their audits. Still, that's primarily a distraction from Sam's main point, which is that audits primarily focus on unintentional errors rather than focusing on fraud.

If audits aren't particularly effective in preventing/detecting fraud, what about government agencies?

As a nation, we devote far more resources fighting blue-collar crime or street crime, than we do battling white-collar crime. For example, the NYC Police Department employs approximately 34,000 cops in uniform battling street crime. However, the FBI employs approximately 13,600 special agents, the IRS Criminal Investigative Division employs approximately 2,600 special agents, the SEC employs approximately 3,958 people, and the US Postal Inspectors Office employs approximately 1,500 postal inspectors. The NYC Police Department has more man power directly battling street crime than those four federal law enforcement agencies combined have fighting nationwide white-collar crime.

While it would be nice to have some estimates of the economic cost of white-collar vs. blue-collar crime, Sam's point still serves as a good illustration of the relative lack of funding oriented toward white-collar crime. Right now, the government seems to have outsourced most of the prevention and detection work to the private sector (e.g., auditors). Until standards or market forces change so that those parties increase their focus on fraud, we appear to be living in a fraudster's paradise.

A Potentially Costly Combination: Deloitte, Taylor Bean and the PCAOB

If you follow news affecting auditors, you may have noticed that the PCAOB made a very rare disclosure yesterday about one of the big four firms, Deloitte. The PCAOB said that Deloitte was previously sanctioned for not being skeptical enough to challenge statements made by management and that they still have problems with this.

Normally, the PCAOB tells the big audit firms what they did wrong and gives them a year to fix it with the threat that they will disclose their failures after a year if the firm doesn't fix it. Well, they decided Deloitte was still dropping this ball so they disclosed it publicly. Importantly, the timing of this ball dropping may have been very detrimental to Deloitte. Here is why...

Supreme Court gives challengers of the PCAOB an empty victory

The WSJ and other news outlets are reporting that the U.S. Supreme court ruled that the PCAOB is unconstitutional. From what I can tell, the ruling basically changes the structure of the PCAOB so now directors can be fired at will instead of "for cause" as before. In any case, the news reports are saying that the PCAOB can continue operating as is. The main change is that the directors have less job security. Talk about anti-climactic!

Director Sought for Financial Reporting Fraud Resource Center

The PCAOB is looking for a director for its planned Financial Reporting Fraud Resource Center.  According to the Journal of Accountancy:

“The Center is intended to complement the work of the PCAOB in improving audit quality in this area, by identifying opportunities and incentives for fraudulent financial reporting,” Daniel L. Goelzer, the PCAOB’s acting chairman, said in a press release. “We believe the Center’s work will raise the awareness of the investing public, other regulators and interested parties of financial reporting fraud.”

According to the job listing, the PCAOB is searching for someone who, among other things, can monitor emerging fraud risks (financial and nonfinancial) and developments (geoeconomic and geopolitical) in domestic and foreign capital markets, industries and public companies and analyze and interpret financial trends, developments and anomalies to identify factors that may contribute to financial reporting fraud.

Catching Up: A Few Links

Another reminder that tax incentives and poor oversight are a great recipe for fraud (via WSJ):

...Des Moines, population 200,000, is dealing with a nasty hangover. A lavish tax-incentive program that brought Hollywood to its doorstep has come to a halt amid allegations of faulty oversight, poor record-keeping and potentially criminal abuse.

Charges were brought against 41 individuals allegedly involved in a widespread mortgage fraud scheme (via NYT):

“The fraud schemes alleged in the cases unsealed today reflect a veritable smorgasbord of scams,” Mr. Bharara said during a news conference in Lower Manhattan. “Whether the economy was going up or the economy was going down, these alleged fraudsters were working feverishly to game the system.” 

Other Madoff Aides Said to Be Tied to Fraud:

The trustee, Irving H. Picard, citing his own findings, asserted that 245 of the almost 5,000 active Madoff accounts were directly managed by other Madoff staff members, not by Mr. DiPascali.

Like Mr. DiPascali, these employees created records of fictional trades that maximized the reported profit in the accounts, the trustee’s filing asserted. Indeed, it claimed those accounts showed bogus profits in excess of the fictional gains recorded in the DiPascali accounts, which ranged from 10 to 17 percent.

According to the filing, the accounts included those set up for Stanley Chais, a Los Angeles investment manager whose clients lost millions in the fraud, and Jeffry Picower, a professional investor who withdrew billions from his Madoff accounts.

The special accounts also included ones set up by members of the Madoff family and employees at the firm, according to the document.

And finally, PCAOB Announces Ambitious Agenda; May Be Time to 'Dial Up' on Fraud, Silvers Says (HT FASRI):

In response to questions, Silvers said, "We should not expect that every audit is a forensic audit... that's absolutely not what I'm saying." However, he added, "I think we need to move the dial a little bit so auditors have some greater obligation than is currently embodied in the current fraud standard, to have an obligation to act when there is reasonable suspicion of fraud."

"This was subject to some extensive discussion in the Treasury committee (Treasury's Advisory Committee on the Auditing Profession or ACAP]," said Silvers, adding, "some people, [e.g.] Lynn [Turner], may feel my approach is not tough enough, some people felt we should move to some absolute liability standard [i.e.] if you don't find fraud, it's the auditors fault; but it's also not my view that looking for fraud is not related to the audit, that doesn't parse with the public's [perception] of the audit profession."

Audit Quality and the PCAOB

The PCAOB, charged with oversight of public company audits, has received a great deal of criticism as of late. Clive Lennox and Jeffrey Pittman add to the debate with their paper, Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms, which was recently accepted for publication in the Journal of Accounting and Economics (HT Harvard Law School Corporate Governance Blog).

The paper focuses on the value of PCAOB inspection reports, which have replaced peer review reports as the primary source of information about audit firm quality. The authors find that:

• PCAOB inspection reports are not a meaningful signal of audit quality to audit clients
• Peer review reports are less informative than they were prior to the initation of PCAOB inspections

These findings imply that we know less about audit quality under the current regulatory structure. This reduction in knowledge causes concern, as a strong, independent audit is a significant deterrant to fraud.

The full text of the paper can be found here.