Opinion

David Cay Johnston

A history of audit failures

By David Cay Johnston
November 11, 2011

The author is a Reuters columnist. The opinions expressed are his own.

The admission by Olympus Corp that it falsified financial reports for more than a decade should not shock anyone. The shock is that, for years, auditors failed to detect such massive fraud.

The failures of auditors to uncover cooked books, which run the gamut from Adelphia to Waste Management Inc, are a cancer on the accounting industry.

The failures go back years. How about Al Dunlap’s manufactured numbers at Sunbeam in 1998? Or teenage con man Barry Minkow’s ZZZZ Best, which turned out to be a Ponzi scheme and collapsed in 1987? Or Equity Funding, with its computer program to fabricate life insurance policies, in 1973? Or the National Student Marketing “pooling of interests” fraud in 1970, which gave birth to the Financial Accounting Standards Board? Or the 1938 McKesson & Robbins scandal, which gave us the first American audit standards? Or Ivar Kreuger’s 20 percent dividends Ponzi scheme in 1932?

That is but a sampling of big frauds that auditors somehow failed to detect, sometimes over many years during which they were supposedly scrutinizing books and looking for verification of revenue and assets.

Olympus’s major businesses include building endoscopes, which let surgeons peer inside the body. How ironic that Olympus’s financial lies festered unseen for more than a decade.

Olympus removed KPMG AZSA as its group auditor in 2009 after a dispute over how to account for some controversial acquisitions, an internal document shows. Olympus told investors at the time that KPMG’s audit contract had expired and it was hiring Ernst & Young.

HIDDEN LOSSES

Olympus acknowledges the scheme dates back to the 1990s, when Asahi & Co, an affiliate of Arthur Andersen, was the auditor. Asahi became a member firm of KPMG International in 2003, and merged with AZSA & Co in 2004 to form KPMG AZSA LLC.

Ernst & Young ShinNihon LLC declined to comment, citing client confidentiality. KPMG AZSA LLC also declined comment.

Modern financial history is chock full of such stories, in which managements at brand name companies hide losses, fabricate revenues, report imaginary profits and claim to have assets that turn out to be nonexistent, all of which supposedly independent auditors either fail to detect or keep quiet.

How can this be? It’s not as if auditing is a nascent field, where the problems are uncertain. New York lawmakers created “Certified Public Accountant” as a licensed occupation in 1896. Britain’s parliament required companies to keep books and let shareholder committees audit them way back in 1845, though the United States would lag that reform by the better part of a century. And the development of internal controls to prevent fraud dates back at least to the era of the Babylonian king Hammurabi, roughly four millennia ago.

It also is not as if we lack for warnings that too many auditors are in on the frauds — either looking the other way or actively helping companies hide financial lies.

Arthur Levitt, chairman of the Securities and Exchange Commission under President Bill Clinton, said in a speech at New York University in 1998 that corporate managers, auditors and analysts were taking part in a “game of nods and winks.”

“Many in corporate America are just as frustrated and concerned about this trend as we, at the SEC, are. They know how difficult it is to hold the line on good practices when their competitors operate in the gray area between legitimacy and outright fraud,” he said.

ACCOUNTING PERVERSION

He cited “a gray area where the accounting is being perverted; where managers are cutting corners; and, where earnings reports reflect the desires of management rather than the underlying financial performance of the company.”

Tony Tinker, an accounting professor at Baruch College in New York who is a leader in the critical accounting movement which favors more robust and skeptical examinations, says “auditors aren’t trying too hard to find stuff. Remember in Waste Management the management and the auditors signed a ‘contract’ to fix the mess, each year, for five years.”

Tinker points to a second problem: the SEC and other white-collar law enforcement agencies “are so understaffed and underfunded” that there is little risk of official inquiry and even less of official action.

Professor Prem Sikka, a reformer at the University of Essex in Britain, notes surveys showing that “as many as 70 percent of auditors admit to falsified audit work” in surveys of countries around the world.

“We need to look at the internal value systems and culture of the accounting firms,” Sikka said.

There is the real problem — the structure and the rules of auditing.

Why do we let corporations pick their auditors? Why do we have only four big firms instead of a dozen, a score or more? Why doesn’t government do the audits, as the IRS does tax audits? Why is law enforcement handcuffed by inadequate budgets and rules that hinder investigations? Why are auditors allowed to quietly resign instead of being required to blow the whistle?

Auditing needs a shakeup, fundamental restructuring and the accounting firms need a serious debate about their failings, practical and moral.

Honest auditors and honest managers need to renew Levitt’s call for fundamental reform. They need to press for actual reform, not just talk, so bad practices do not drive out good.

Until we get structural reform the history of gross failings by all of the Big Four are sure to continue. And that means no one’s investments can be safe.

Comments
11 comments so far | RSS Comments RSS

“the SEC and other white-collar law enforcement agencies “are so understaffed and underfunded” that there is little risk of official inquiry and even less of official action.”

I respectfully disagree. An “understaffed and underfunded” agency that is competent and motivated will prioritize it’s limited resources to publicize and prosecute the most certain and outrageous of transgressors. That is their JOB.

The problem is that these agencies and people are NOT doing their job. Accordingly, it would be folly to reward them by giving them even more money and people to do nothing. This problem is rampant and endemic in government at all levels even this far into the current fiscal desperation and reviews. Why? Why? Why?

Posted by OneOfTheSheep | Report as abusive
 

I once worked (as temporary agency staff doing data-entry) for a company that did nothing except statistical analysis of market penetration rates.

Their work was commissioned by the marketing departments of their clients (who had a vested interest in proving that they were succeeding in getting their company’s marketing brochures into the broader market). Anyone see a problem with this setup?

The company I was working for at that time had recently won the contract from a competitor, whose report had displeased the client’s marketing managers (they were “totally convinced” that the competing auditor’s report did not reflect reality). When the numbers came out showing that the competing auditor’s figures were accurate, my managers started looking for ways to make sure their new client would stay with them…

I was fired from that job for refusing to “cook the books”, to monkey with the numbers so as to please the people who commissioned the report. They got another temporary staff member to do it for them instead. After sending the “finished” report back to the client, the client called their new auditor on the telephone to say,
“Thank you for your report – your figures were exactly as we had expected. We shall be doing business with you again in the future [and not going back to our old supplier].”

Of course this market “research” auditing company (that defrauded Airtours, a UK travel agency, and their shareholders; and probably others as well); found some other excuse to fire me. They reported to my employment agency that I had some weird idiosyncrasies and that they wanted me replaced…

Nothing idiosyncratic about honesty, is there?

Posted by matthewslyman | Report as abusive
 

I tend to agree with OneOfTheSheep, however the GOP is doing everything they can imagine to gut regulations, eliminate enforcement, and defund oversight. I agree the SEC and other agencies need to do their jobs right, and auditors who allow cooked books need jail cells, but having our legislators undermining valid efforts is contempable.

Posted by Indydog | Report as abusive
 

None of these abuses were “invisible” — they were just “inconvenient” to auditor management. The managers who ignored them should simply go to prison.

If you do not want to be squeeky clean honest, do not work in auditing or in Government. As a country, we need to fill our prisons with white collar crooks and Government officials rather than marijuana smokers. There is no comparison whatsoever in the amount of damage to our country caused by the two groups.

Get tough with white collar crime or collapse. That is the simple choice. Prosecute, prosecute, prosecute! The laws are already there. If there is any part of our legal system that needs to go into the sewer, it is the doctrine of “sovereign immunity” (tell it to Louis XVIII). That simply invites criminals to have their wicked way with the people. It is a vile, vile concept.

Posted by txgadfly | Report as abusive
 

The astonishing inability of the audit profession to identify cooked books is deeply disturbing and is now putting capitalism itself at risk. How did the audit profession become so useless? I outlined some of the reasons in mu Qfinance article, published in January 2011:- http://www.qfinance.com/blogs/ian-fraser  /2011/01/24/accountancy-sacrificed-its- right-to-call-itself-a-profession-long-a go Also to watch a phenomenal and followed it up with this one in July http://www.qfinance.com/blogs/ian-fraser  /2011/07/07/accountants-who-dont-want-t o-be-conservative-or-prudent-are-serving -capital-markets-ill I’d also strongly recommending this interview with Berkshire Hathaway vice-chairman Charlie Munger in which he likens the accountancy profession to a sewer:- http://www.ianfraser.org/charlie-munger- getting-accounting-integrity-right-has-e normous-implications-for-future-of-manki nd/

Posted by IanFraser | Report as abusive
 

Corrected version of comment:-

he astonishing inability of the audit profession to identify cooked books is deeply disturbing and is now putting capitalism itself at risk. How did the audit profession become so useless? I outlined some of the reasons in this Qfinance article, published in January 2011:- http://www.qfinance.com/blogs/ian-fraser   /2011/01/24/accountancy-sacrificed-its- right-to-call-itself-a-profession-long-a go

I followed that up with this article in July 2011 http://www.qfinance.com/blogs/ian-fraser   /2011/07/07/accountants-who-dont-want-t o-be-conservative-or-prudent-are-serving -capital-markets-ill

Finally, I’d also strongly recommend watching this interview with Berkshire Hathaway vice-chairman Charlie Munger, in which he likens the accountancy profession to a sewer http://www.ianfraser.org/charlie-munger- getting-accounting-integrity-right-has-e normous-implications-for-future-of-manki nd/

Posted by IanFraser | Report as abusive
 
 

David parting shot pleading for the auditors / regulators to clean up their act is, what sociologists like to call, “political voluntarism”. The Big 4 Accounting Firms are one of the largest lobbying groups in Washington. They are are the ‘regulated’ who basically own the regulators. Their law department out spend and out gun the SEC who constantly forced to settle for a ‘cease and desist’ order (which, incidentally includes a codicil that all records of an misconduct (often fraud) are sealed, to obstruct further private litigation, and deny Professors from conducting the equivalent of an autopsy to teach students how to ovoid a repetition of the ‘disease’.

Posted by tonytinker | Report as abusive
 

Government agencies are vulnerable to the same problems as the Big 4. A problem with the Big 4 is that most people work the long hours at these accounting firms to land good jobs at the clients. Much like the SEC preference of hiring accountants with Big 4 experience.

Having government conducted audits would just result in a greater degree of regulatory capture at agencies like the SEC and CFTC than already exist. The SEC itself has a poor history of not retaining required documentation of investigations that it has conducted. Last firm I heard of losing/shredding documents was Arthur Anderson.

Posted by smiller29 | Report as abusive
 

I retired after more than 40 years in the auditing profession with the same firm throughout starting off with a ‘big 8′ Firm and ending as a partner with a successor ‘big 4′ Firm. Approximately 85 percent of my career was spent in South East Asia. I take issue most strongly with the assertion ..” as many as 70 percent of auditors admitted to falsified audit work”. In my entire career, and I worked in an extremely large office during the last 15 years of my career, I have never falsified any audit work, been associated with any falsified audit work, or been aware of any falsified audit work in the various offices of the Firm where I was assigned.

Audit failures do of course occur, but I would suggest the reasons therefor are mainly due to lack of audit judgement/focus, notwithstanding the rigorous requirements of ‘big 4′ Firms’ specified audit methodologies or due to client collusion/fraud.

I note once again that I have retired from the accounting profession and that I do not have a guilty conscience or axe to grind based on my career in the such profession, which included numerous large, challenging audit assignments. I firmly believe that many authors of articles on this subject have never experienced any significant period in the audit profession or appreciate the professional challenge in getting ‘audits right’ throughout one’s career, as is in fact the case for the vast majority of audit partners and staff in ‘big 4′ Firms.

Posted by Anonymous | Report as abusive
 

Why can’t we find common ground in this debate?

Perhaps its because “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”

Posted by DrRajT | Report as abusive
 

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