Regulating Audit Firms: News and a Short Wishlist

In the last week, some news agencies have reported that the PCAOB is investigating the role of auditors in the financial crisis. It appears that auditors have been able to avoid much scrutiny from the latest economic meltdown whereas when the dot-com/telecom meltdown took place around the turn of the millennium, auditors took much of the blame. Below is a rundown of the two recommended regulatory changes that are being talked about in the news followed by a short discussion of changes that I would make if I was in charge.

Credit Agencies and Auditors

There has been a lot of press lately about the three credit rating agencies, Moodys, Standard and Poors, and Fitch, and their role in the credit crisis. In particular, some have pointed to the fact that companies hire these credit rating agencies to rate their securities and this creates a conflict of interest that leads to higher ratings. The same criticism has been lobbed at financial statement auditors for decades--especially when there have been some highly publicized audit failures involving undetected fraud. Interestingly, Congress is doing something about this conflict for the credit rating agencies as described in a recent Bloomberg article that says:

Rating Agencies and The Great Recession

There is a provocative editorial in Saturday's NY Times that criticizes Moody's, Standard and Poor's and Fitch for their role in rating the subprime residential mortgage-backed securities and C.D.O.’s that turned toxic and led to the failure of numerous financial institutions. The article states that these securities were rated as AAA investments or as safe as U.S. Treasury Bonds! It also argues that the fees paid to the rating agencies create an independence problem akin to auditor independence issues. It's interesting that this significant "assurance service" is rarely scrutinized and has managed to stay out of the spotlight even during this current economic meltdown where they were heavily involved.

EY settles with the SEC

This week, the NY Times reported that the SEC reached a settlement with EY for its audits of Bally Total Fitness. The article reports that "Six current and former Ernst partners, including Randy G. Fletchall, the partner in charge of the firm’s national office, were ... sanctioned by the commission in one of its most sweeping actions against auditors involved in a failed audit." The SEC's $8.5 million settlement is reported as "one of the highest ever paid by an accounting firm.”
Here are a few quotes:

“It is deeply disconcerting that partners, even at the highest levels of E. & Y., failed to fulfill their basic obligations to the investing public by not conducting proper audits.”

“This case is a sharp reminder to outside auditors that they must carry out their duties with due diligence."

"Mr. Fletchall, who remains with Ernst, was in charge of resolving technical accounting issues in the United States ... was censured by the commission."
"A veteran S.E.C. official ... said he knew of no previous enforcement cases in which a partner of a major firm was cited for his actions as head of a national office."
"Ernst was reacting in 2002 to a growing number of accounting scandals, including Enron, and decided to get tough with clients who had previously been allowed to take aggressive accounting positions. The firm forced Bally to stop recording revenue in an improper manner that allowed it to claim earnings earlier than was allowed by accounting rule. But in doing that, the firm allowed Bally to not admit to having violated the rules in the past, an action that would have forced it to restate its accounts and admit that losses in previous years had been much larger."
"The case could provide support for reformers who have said companies should be forced to periodically change accounting firms, a change that Congress considered but rejected in passing the Sarbanes-Oxley law in 2002."

What is this guy thinking?!

The more I read about the former auditor for Bernie Madoff's Ponzi scheme, the more questions I have about this guy. The WSJ reported that Mr. Friehling said that he is a victim of Madoff's scheme too. According to the article, Mr. Friehling revealed that "he entrusted his own retirement and his family's investments to Mr. Madoff, saying he had about $500,000 with the firm." I'm starting to think Mr. Friehling knows about as much about auditing as the typical High School student! Doesn't he know that an auditor is forbidden to invest in a company that he audits?! This is basic auditor independence! Something is missing here...but it may just be that Mr. Friehling is missing something...