Nothing to see here: Part 1, Failure to report …
If you can’t report the news on time, the news you eventually report is almost always bad. I formulated this theory in 1977, and it’s served me well ever since.
It was a time of tight jeans and floppy hair
As the subprime mess reaches saturation of troubled borrowers and dissipates into tardy omnibus rescue legislation and endless financial recriminations known as torts –
“Hey, can I have your torts?”
– the next group to face tort fallout will be the auditors.
“If you keep your torts in your pocket, then no, I don’t want any.”
As I’ve previously posted, in Banking on Value and Resell or Farm?, capital providers involved with highly complex assets want all that volatility and risk reduced to a handful of numbers – a value and a risk rating.
As homeowners, shareholders and federal investigators pick through the subprime wreckage, many have asked how effectively front-line financial monitors carried out their duties. Ratings agencies responsible for signing off on the creditworthiness of securities, and regulators responsible for overseeing banking practices and safeguarding the entire financial system, have already been roundly criticized for not sounding alarms earlier.
For risk rating, investors have relied on rating agencies; for valuations, they look to auditors.
Now, attention is turning toward yet another steward of financial reporting ensnared in the subprime debacle: accounting firms.
What, we didn’t give you proper warnings?
What happens if, as this New York Times article suggests, the auditors are asleep at the switch:
A Lender Failed. Did Its Auditor?
It begins, as many newspaper stories do, on a personal level with our author-surrogate protagonist:
ALTHOUGH he had been with the mortgage lender New Century Financial for only two months, Tajvinder S. Bindra had spent a good part of late 2006 and early 2007 pelting the company’s controller and a member of its auditing firm, KPMG, with questions about the company’s accounting.
Enough with the questions already!
Frustrated by their responses and staring down a deadline to close New Century’s year-end books, Mr. Bindra, the company’s chief financial officer, told both men that he needed written assurances from KPMG that New Century’s bookkeeping was proper, according to accounts of the discussions.
If his employment agreement (posted online!) is anything to go by, Mr. Bindra had joined New Century only in late October, 2006, long after the rot had set in that would shortly sink the company. As I posted last March, when it happened:
Oh my paws and whiskers, the audit’s overdue
Meanwhile, what tipped New Century into the soup was this cheery announcement only a week before:
Federal prosecutors and securities regulators are investigating stock sales and accounting errors at the New Century Financial Corporation, the biggest mortgage company that specializes in lending to people with weak, or subprime, credit, the company disclosed in a corporate filing yesterday.
“Stock sales and accounting errors” are the phrases one might use if the captain and crew were dashing for the lifeboats even as the ship was sinking.
We’re still making journal entries
Under Sarbanes-Oxley, the reform that followed the Enron catastrophe, Chief Financial Officers are right in the firing line.
When the CEO goes down, you become the flag-carrier
Along with the CEO, they are personally liable for misstatements in the financial reports.
So Mr. Bindra, like his fellow CFO’s, was doing exactly the right thing. He wasn’t present when these things happen; he was relying on reports others had provided. He needed those affiants to stand behind their affidavits.
But KPMG balked.
I Balk when you ask me to use my Craft that way
A few weeks later, on Jan. 31, 2007, KPMG and New Century’s own accountants stunned the company’s board by revealing that the lender had incorrectly calculated its reserves for troubled home loans. That mistake was likely to cost New Century $300 million, wiping out all of its profits from the second half of 2006.
From the New York Times: “Those profits we booked? Well, they never existed.”
Profits are critical to shareholders, and not just for the obvious reason that without them, shareholders get no earnings. Profits are proof the business is being well managed.
New Century’s accounting methods let it prop up profits, charming investors and allowing the company to continue to tap a rich vein of Wall Street cash that it used to underwrite more mortgages. Without the appearance of a strong bottom line, New Century’s financial lifeline could have been cut even earlier than it was.
Not my credit rating!
While accounting firms don’t exert legal or regulatory authority over their clients, they do bestow seals of approval, the way ratings agencies do.
Way to go!
The presence of profits is intrinsically comforting, whereas their absence automatically invites questions.
People in the financial industry, as well as investors, have reason to believe that a green light from an auditor means that a company’s accounting practices have passed muster.
Zach Gast of RiskMetrics said better accounting at New Century would have raised flags sooner, perhaps tempering the subprime fiasco.
“It would have had widespread repercussions for the lenders who were buying loans from New Century,” Zach Gast, an analyst at the research firm RiskMetrics, said about the possible impact of an earlier profit warning from the lender. “It may have even accelerated the whole downturn of the subprime market.”
More than mere reason to believe: if the auditor’s letter is not reliable that the financial statements are presented fairly, then it is meaningless.
Is it or isn’t it?
The interpretive waltz between a company and its auditor, of course, can be complicated and open to varying perceptions.
Accrual-basis accounting is more than mere arithmetic. A mortgage or loan transaction has a lifespan measured in years and even decades: I give you money once, today, and you give me money every month for years and years. My ‘loan’ is a piece of paper that describes what you have promised to pay me, and what I can do if you do not. My piece of paper thus has value only if I can actually collect those future payments, and my ability to collect may be impaired from a dozen different causes. Some of these impairments are immaterial; some are temporary. Some are permanent, others are fatal.
When the assets in question are not just individual loans, but whole pools of loans, or securities derived from those loans, then judgment comes into play – judgment informed by data.
Ladies, I need more data before I judge
The auditors do not know as much about their client’s business as their client does, so any professional worth his salt will always look to the source for more evidence. (”Data, more data!” as a CBO friend of mine used to shriek when people questioned her conclusions.)
Where does evidence become argumentation? When does analysis become propaganda?
When I can’t understand it any more?
Still, some accounting experts question how appropriate it is to take auditors to task for judgment calls that, even in hindsight, are hard to make.
“I think it’s a stretch to blame everything on the accounting profession,” said
We don’t want much – just auditors who are infallible.
Keep the lights switched on
Analysts say that auditors, because of in-depth knowledge of complex accounting rules and first-hand relationships with corporate management, are there to push back, examining how executives calculate numbers and assessing the financial health of enterprises.
An auditor should be skeptical, even cynical … but at the same time, open to new evidence, modest, and dispassionate.
In New Century’s case, the court examiner, Michael J. Missal, concluded that KPMG was not skeptical enough and that the lender’s creditors could pursue negligence and negligent misrepresentation claims against the auditor.
I doubt Mr. Missal found KPMG insufficiently skeptical; rather, he likely concluded that KPMG’s self-exculpation was unproven, leaving open the possibility that it was credulous.
I have to read the books
But the examiner did not accuse KPMG of fraud or intentional wrongdoing. The examiner said he also “did not find sufficient evidence to conclude that New Century engaged in earnings management or manipulation.”
In other words, the auditor exonerated neither KMPG nor New Century. Unleash the lawyers!
Maybe I should let go of the leash?
KPMG strongly contests any suggestion that it was derelict in its duties or that it went overboard trying to retain a well-paying client. It resigned from its New Century engagement shortly after the lender filed for bankruptcy, and it never completed the audit of the lender’s statements for 2006, the year in which New Century’s accounting was at its most improper, according to the examiner.
KPMG refused to sign the audit, and it resigned the assignment. For 2006, what else could it do?
KPMG says that it’s unclear whether the examiner’s conclusions are derived from objective evidence available at the time it worked for New Century, or simply represent assumptions that are now being made in hindsight.
Alas for KMPG, those are the circumstances under which its conduct will be scrutinized – after the fact, after the collapse
Apres moi, le deluge
Others will sort out whether KPMG was legally culpable; to me that’s of less interest than what should be their proper standard.
Have fun suin’ the auditors!
[Continued tomorrow in Part 2.]
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