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October 17, 2005

Unrealistic expectations of auditors, Mon., Oct. 17, 2005, 9:13 AM

Is it an auditor's job to find fraud? Well, in the case of the Bayou Hedge Fund fraud, the principals secretly owned the auditing firm. Isn't that the ultimate case of playing with yourself, and anybody else unfortunate enough to participate?

But the Grant Thornton CPA people are now going to be sued and harassed over the fact that the principals hid a major fraud. Is GT responsible? I think not.

Refco Inc lead underwriters Goldman Sachs, Credit Suisse First Boston and Bank of America Securities clearly had a responsibility to know that the IPO product they created and sold was not a scam. That is the nature of the contract between seller and buyer.

If the seller finds they in turn were defrauded, I believe they have legal recourse based on contracts between the parties.

But what is the contract between a reporting issuer and its auditor? Based on my five-year's auditing career at KPMG and PwC, where I departed holding the designations CA and CMA, I have the following view.

The external auditors are provided financial summaries by the company and have the responsibility to report to stakeholders that these financial summaries are "fairly presented in conformity with generally accepted accounting principles." That's it.

However, because of major accounting scandals in recent years, the external auditor has had to spend increasing resources to assessing internal control procedures. That means the CPA firm has had to work closer with a client's internal auditors, who are employees whose job it is to ensure no fraud exists in that company.

Fraud in this case is an act to conceal a deceit. If a CEO perpetrates a fraud by making a statement that x equals x when in reality x equals y, and there are no independent parties who could inform the auditor that x really equals y, then how is the auditor to know?

In any test of reasonableness I ever saw, the auditor in this case is going to pass. If finding that x does not equal y is an impossible task, and it often is, then the auditor cannot be held responsible. And that's why nowhere in the auditor's contract is there a covenant related to the uncovering of fraud.

Of course if a company's internal control procedures are so lax as to cast doubt on the quality of the year-end financial audit, the external auditor is duty bound to resign. Given the seriousness of such an act, readers can be assured that the audit working papers, which are not protected by legal privilege, would be chock full of staff notes and correspondence with the client in that regard.

There occasionally is an issue, I think, where external auditors give the client too much latitude. That may be a failure of judgement, which I suppose could be found to be a legal error.

But my point in this article is that there are many cases where the stakeholders have to cut the auditor some slack. There are indications that the Refco Inc fraud is possibly one of those.

Posted by Posted by Bill Cara on October 17, 2005 09:13:44 AM | Category: Yada yada

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