Personal experience. I’ve worked with tons of auditors that don’t know what to look for or even what they’re looking at.
Bromion, I got 2 questions for you?
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Since this is an anonymous board, would you care to reveal a few examples of companies you suspect are comitting fraud in their reports?
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Would you say that JohnyMac’s description of what b-school students did to discover Enron is the same method you use more or less?
I can only give you my “opinion” for legal reasons (even though this is an anonymous board) and because most of the frauds go unsolved even though they meet the definition of fraud. I would suggest you look at UNXL (which is currently under investigation by the SEC but hasn’t been proven a fraud). The rest of the frauds I have looked at are ongoing so I won’t mention them.
Johny mentioned some quantitative metrics and those are a good place to start.
Interesting that your experience chatting up a few junior auditor hotties fresh out of school while they do battle with the copy machine would enable such a sweeping conclusion about the management of these audits LOL
Thanks for allowing me my personal views…but if you don’t mind I’ll make my own mind up about whats still up for debate and even whats worth debating!
Good discussion all.
Sorry, you’re just wrong. I spent a month of the summer researching this in depth and have run all the numbers over the last decade.
Ha ha well OK then Bromion…you get the last word Bro (keep running those numbers and researching in depth!)
The revised consolidation rules make Enron’s SPE shenanigans near impossible to replicate. Derivative requirements have also gotten pretty robust, so its hard to have significant off balance sheet items that escape disclosure.
I’ll take Bro’s side on this one. Currently the organization I’m at is undergoing its annual audit. As part of the annual audit, there is a goodwill impairment test. I was in the inner sanctum when I heard the CFO tell the Lead Audit Partner in so many words, “We are not going to take a goodwill impairment, so let me know what assumptions we need to assume to avoid it.” We are using a Big 4 too. There it is folks. The tail wagging the dog. I was in another organization years ago when I overhead the same thing was said regarding a qualified opinion potentially being issued.
This is fairly normal. The accounting rules on this are very vague, and there’s a lot of gray area.
If you’re NOT taking an impairment, then there’s nothing to examine. However, if you ARE taking an impairment, then it’s not incumbent upon the auditors to do the calculation, but merely to confirm whether or not it follows the very vague accounting rules.
Of course, the auditors and management have an incentive to agree on this. If the auditors are too stingy, then management will take their business elsewhere. And if management is too aggressive, then the auditor’s aren’t going to risk their professional reputation one just one client.
It’s not much different from taxes–you can deduct anything in the world that you want. Just make sure that when the IRS comes knocking, that you have some basis for your position, and that you can point to it in the tax code.
Big 4 Auditor here.
To your point of the ‘audit business not caring’, I couldn’t disagree with you more strongly. Our objective is to ensure that the financial statements are presented fairly in all material respects, which hinges both on appropriate accounting from a transactional perspective as well as non-fraudulent financial reporting or misappropriation of assets. I’ve audited quite a few public companies and can assure you that the absolute primary consideration is the shareholders. The shareholder group is the biggest factor considered in determining materiality, which then has a 100% correlation to the amount of testing that is performed over each GL (not each financial statement item, we’re talking each individual GL. A company with 50 FSLI’s could have 3000+ GL accounts).
The Enron fraud is obviously the most extreme possible example of collsion and independance issues, so it’s easy to use this as a basis to say the audit industry is colluded itself.
During an audit, we perform substantive/analytical/controls-based testing to directly address the key risk assertions (completeness, existence, occurrence, presentation/disclosure, accurary, measurement, rights & obligations). Our assessed level of risk for each business process additionally factors into the amount of testing required to obtain enough assurance to reduce audit risk to a sufficiently low level (the risk of issuing an incorrect opinion).
In the absence of independence issues between AA and Enron, a few things could result in the auditors missing fraud
1 - inappropriate assessed level of risk for each business process which leads to insufficient level of testing
2 - Insufficient level of substantive testing to support analytical procedures, even if level of assessed risk was appropriate
3 - Management did not properly disclose all related parties. If management doesn’t disclose related parties with which they have material transactions occurring during the year, it is extremely difficult for auditors to notice this issue. Even if we were to substantively test AR/AP/Sales transactions with a particular party, the highest level of assurance we could obtain would come from sending the company a confirmation and request them to confirm that the values presented in the company’s subledger are accurate. If the company is colluding by having non-independant individuals ‘run’ these companies and respond to the confirmation, then it’s not really possible for us to conclude that the party is related.
Respective to accounting policies, the accounting policies used to transact material business processes are discussed with management. Managements policies are contrasted and compared with guidance provided by the relevant financial reporting framework to determine if they are reasonable and relevant, and whether any differences between management’s policy and the framework result in a material variance (which, if unadjusted, would result in a qualified opinion and disclosure via emphasis of matter in the audit opinion)
As an auditor, and hopefully at some point in the mid/distant future a CFA charterholder, if I see an audit opinion issued on a set of public financial statements I’m comfortable that they are in fact free of material misstatement. In the absence of collusion by top management, it is unlikely that the statements are misstated to the extent that your economic decisions would be innfluenced.
With respect to the OP - no, I don’t think it would have been possible for someone to conclude with any reasonable amount of confidence that there was fraudulent financial reporting ocurring. I think that you may have been skeptical of some of the revenue-generating processes, but having been audited the risk of material misstatement there would have appeared to be nominal. Non-disclosure of material related parties is difficult for an auditor to detect, let alone a user of the financial statements.
Keep in mind that all SEC-registered companies have their audits subject to PCAOB reviews, which is an independant governing body that ensures the auditor has appropriately assessed risk levels for material business processes, and reviews all audit working papers for these processes to ensure an adequate amount of testing has been performed to reduce audit risk to a sufficiently low level. PCAOB penalties for non-compliance are very, very stiff, and can result in a partner losing their designation if the infraction is serious enough. That aside, PCAIB discloses the results of their reviews, so if a firm consistently fails PCAOB reviews it’s unlikely they will be able to retain public clients simply because the perception of quality is not there, and the users may lack faith in the auditor’s opinion.
^ That’s all fine and dandy if you want to grandstand at a CPA convention. Given what I just heard inside of the inner sanctum and what bro has spelled out, I’m not so sure the level of indepence is as high as we would all like to believe.
Let’s look at it from a personal standpoint. Say the CFO is pushing the envelope, nothing illegal, just something that is teetering the GAAP compliance line. If the lead audit partner questions this, the CFO is going to stand his/her ground since they will probably lose their job should this scheme come to light. Now the CFO isn’t going to roll over and take the CPA buttfking. So then he throws out a power play and implies, “You know, this is GAAP/IFRS compliant and this is how business gets done in our industry (financial services circa 2008). If you’re not going to help us, we’ll find someone who will.”
Now the lead audit partner is sweating. Losing this client means he or she will likely lose their job.
Both parties now have a problem. Seeing as they care about making their own mortgage payment more than some faceless shareholder zip, I can bet we all know the direction they’ll take.
I remember from L1, goodwill must be tested for impairment annually. The ‘test’ at my organization is already concluded before the examination has began. The CFO told the audit partner we are not taking any impairment. Now the Big 4 storm audit troopers have to reverse engineer the test to assure goodwill is in tact. I have no clue if we’d have an impairment or not, but the fact the CFO had his mind made up before the test began, the independece now strikes me as a moot point.
@sglondon - I’m not necessarily disagreeing with you, but your first post sounds like something that came straight out of an auditing textbook, or a canned speech that a person taking the witness stand might say.
I don’t know if you’ve ever been a Controller, or worked in Financial Reporting, but do you not think that some of what CvM says is true? You don’t think that the CFO and Controller get together and figure out how they can toe the line to increase the bottom line? Or that they won’t try to recognize revenue or decrease expenses (temporarily, of course) to try and meet analyst’s estimates for this quarter?
EG - when I worked in Sales and Local Tax at the publicly traded company, I knew of a $150,000 receivable that we kept on the books, because we filed for a sales tax refund a couple of years earlier. After two years, we still hadn’t received it, and we knew that we weren’t going to receive it. However, the Controller wouldn’t credit the receivable out, because he knew that he’d have to debit something, which would manifest itself on the net income somehow.
If the CFO is going to lose their job as a result of a ‘scheme’ coming to light, then it’s not something that is IFRS/GAAP compliant, and certainly wouldn’t allow the partner to issue an unqualified opinion. I challenge you to provide a practical example of a situation like the one you described.
I realize that my first post was very general, but I don’t get the impression that the vast majority of people posting in this thread what an audit really comprises of, and therefore don’t have a sound basis to say they don’t place comfort on an audit opinion.
Keep in mind that an audit is intended to ensure that accounting policies used by management are in accordance with the financial framework. Also keep in mind that changes in accounting policies require full retrospective restatement , so management can’t just change their policies each year to meet reporting objectives. For items that require management estimate, a more likely way for management to present figures more in line with reporting objectives, the auditor obtains assurance over each individual assumption and determines whether the figure being presented, as a result of the cumulative variables influenced by management’s estimate, is free from material error. If it is materially misstated, the auditor posts an adjustment.
For something blatant like a long outstanding receivable; this is something that should easily be picked up during an audit. If your company has the ability to provide a subledger or AR aging report and the auditor sees that there are receivables outstanding significantly longer than the entity’s normal credit terms, management would need to have very, very solid reason, and substantive evidence not to allow for this amount (personal guarantee from owner, secured asset, for example).
The test HAS to be done before the audit takes place. The financial statements have to be issued before the audit takes place. Remember that the financial statements are the responsibility of the CFO, not the auditor.
And yes–goodwill impairment is one of those wonderful things that can be used for income smoothing, because the test is so open to interpretation. You can impair goodwill to take a big bath, or you can use to lower EPS for this quarter (if you believe you’re having an exceptionally good quarter, and you want your earnings to be lower, presumably so they’ll be higher later). If the goodwill really was impaired, then it will have to be recognized eventually, but the CFO/Controller have a lot of say in the timing of the impairment.
This being said, I’m quite certain that your CFO was engaging in some form of earnings management. Maybe not particularly sinister or malicious, but earnings management nonetheless. And I believe that a great deal of it goes on. That’s not to say that the auditors are incompetent or complicit, but the auditors simply can’t cover everything.
Sglondon can say that they cover every single GL account, but I bet that if the CFO were to give them a letter saying, “We looked at goodwill this year and decided that it was not impaired”, then they probably won’t spend just a whole lot of time on it. They’ve got 2,999 other GL accounts to look at.
Even if they did try to re-perform the test, do you really think they have the technical expertise to be able to gather and interpret the information? Remember–they’re not only auditing this company, but a myriad of other companies too. Do they have the expertise to do a goodwill impairment on Exxon AND Bank of America AND the Dallas Cowboys AND Pepsi AND Target? These are five extremely different companies, and their goodwill is extremely different and the test will also be extremely different.
FYI, I appreciate your contrast to my post. What I said was not intended to be a diss.
Financial services circa 2008. I talked to a CEO of a IB during that time who had an informal inquiry by the SEC. The SEC said in so many words, “You’re pushing the line on legalities here, why don’t you stop this practice?” The CEO said in so many words, “We can’t. This is how the industry has become.”
It relates one in the same to audits. You can’t tell me competative companies go by the book on every single GL. Some are taking an aggressive accounting approach to remain competative.
I could see a board removing a CFO who took a conseravtive approach in accounting which dropped EPS and therefore destroyed shareholder value.