sid3699, I am in my first year of auditing and have to say you make some good points as to what an audit should theoretically be in a perfect world but the underlying nature and legal requirements are far different. In fact, if they stated everything you ask for they would probably end up beng sued a lot more. Financial statements in no way are meant to be used for future investment decisions or to base investments on. That may sound ridiculous but financial statements are backwards looking, unless it happened in the previous fiscal period or there is a blatant chance of bankruptcy nothing of the future is noted other then contigent liabilities and similar future cash outlays that are required to be disclosed. Audits are first and foremost to verify the representation of past events over a fiscal period and asset/liability value at a given point in time based on GAAP and that the statements which are made by management are not materially misstated. When it comes to valuations, they take a look at the assumptions and the models to check for reasonableness, they dont go and thoroughly investigate every input and possible variance. They check the main underlying assumptions, the liability given a certain percentage change in either direction, make a note of it, and see if it is acceptable given the stated materiality. If actuaries are involved, they check it and usually sign off with whatever the actuary concludes. Unless the entire industry is in decline, the business is losing major clients and cash flows are not sufficient to meet the costs of day-to-day operation they won’t issue a warning about the going concern. If the investment banks and firms you mention had stayed in business through one more reporting period there would have been the warnings you were looking for but as financial statements arent meant for you to make investment decisions they weren’t forward looking and didnt forsee this debacle. If auditors only have to make a reasonable effort based on risk characteristics and the projected expectations to find fraud, then how would you expect them to be the ones to rate the viability of all these level 3 assets if even the financial engineers who made them couldnt value them?..like someone said before the rating agencies should have been the ones to raise the flag first.
Actually lol I change my mind…sid is right…if the auditors had done a good enough job and followed the strategic systems approach and known the managements strategies, managements analysis of the risk and the risk management systems in place they should have been the ones raising the flag first. They should have seen the increased inherent risk in the audit clients…again disregard my previous post.
look accountants have to follow accounting standards and none of them focus on going conern or even forewardd looking - and the information is all historical … by the time the audited financials are signed … the company’s balance sheet has moved on … .know the limitations and use it as a snap shot … you want accountability … what about management… about analyst who go in and analyse values and cash flows … hey those who are in the analyst field should have accountability and should speak up … but like the cfa material … no one wants to be the whistle blower … so before you throw the first stone …we should look at ourself and the part we play.
I agree it is an opinion “at a point in time”. But I don’t, won’t, agree that auditors don’t focus on going concern. The review of internal controls, impairment analysis and risk management is all done JUST to answer the big question–is the company able to operate soundly going forward"BASED ON INFORMATION TODAY?" Nine months of turmoil, especially, in the valuations space was enough time to make a call. If PwC could make it for AIG, E&Y also should have raised a red flag for the real estate valuation especially given the large exposure in the Level 3 bucket. As far as analysts go, although they are not directly answerable to public their credibility is hurt when their call on the stock is messed up. All those who had a buy rating on LEH, for example, have lost significant client confidence. No two ways about that. Hell, even their own traders would be hating them as the traders might have taken a prop. position based on the analysts fundamental view. On the sell side if an analyst’s credibility is gone, that is the worst thing. Edge, am not sure if you have worked at the BIG 4, but the partners are very reluctant to go against the management especially if the client is as big as LEH. That is why I said, the word “independent” in the annual report is a sham. I still conclude–Regulate the auditing industry. Make it part of Paulson’s grand plan.
New regulation is not the solution to this. Withh all due respect to auditors, how can you expect them to revisit complex valuations or question assumptions? It’s often very difficult to value a single investment and reasonable people can disagree all the time. Suppose that you have a portfolio of CDS on various CDO tranches and you have to value them when there is no market for the securities. You make some model of interest rate movements, some model of default correlation, some model of cash flows based on previous two, get out your random number generator and come up with an expectation and some measure of uncertainty. The first problem is that there is no assessment of uncertainty in financial statements. It would be a brave new world if balance sheets reported shareholders equity as a confidence interval. Even if there was an assessment of uncertainty, it’s based on the model assumptions and it’s not clear that anybody is qualified to be the arbiter of model assumptions, to say nothing of an auditor with an education in accounting not mathematical modeling, quantitative finance, etc… (BTW - I am not suggesting I want assessments of uncertainty on financial statements). This is one of those problems we know the solution to. The model that says that anybody is smart enough to value anything complex is silly. However, the collective actions of everyone might be smart enough. It’s surely smart enough to compare similar securities on the books at LEH and AIG and say that AIG’s couldn’t be worth twice as much. An AIG auditor almost certainly has no idea what is on LEH’s books. The solution to this is not to regulate auditors but to define their mission more like checking on the veracity of the statements. Let disclosure take care of valuation decisions. Should the auditors have issued a qualified decision about LEH or doubted its ability to continue as a going concern? It depends on whether you think that an auditor should be able to do that if a company’s business plan was risky. That asks an auditor to be able to assess firm-wide risk, which is way too big a job for an audit team.
BIG 4’s have in house valuation teams that value securities–real estate, intangibles, stock compensation, etc. I was part of such valuation group. The audit team has very little idea what the valuation is. They rely on their valuation group. These valuation groups then come up with their own valuation based on the current facts and figures and most importantly “talks with the management,” and more often than not, it goes the management way. I agree audit teams cannot assess the firm-wide risk, but the issue with LEH was honed on real estate valaution. Nine plus months is too long a period in this bizzare climate to not raise a red flag at the very least. I totally agree better disclosures would help, but it does’nt solve the problem of dodgy valuations. The craziness of a Level 3 bucket valuation, by selecting any arbitrary discount rate, must be addressed. The auditors sign off on such discount rates because management said that is what the discount rate should be. It’s time auditors stood up and said, “we are not your puppets, stop this shenanigan,” and am not sure this would happen without government intervention.
I can’t imagine arguing with an auditor or really any accountant about complex security valuation. How’s that going to work? At 45, I know all kinds of senior accountant types and not one of them would spend 4 seconds arguing with me about security valuation. They’re accountants not quants.