PWC Held Responsible for Not Detecting Fraud

The Wall Street Journal published an article explaining that PricewaterhouseCoopers (PWC) was held responsible for failing to detect fraud in their independent audits of Colonial Bank. Colonial Bank collapsed in 2009 and, according to the Tampa Bay Times, was the sixth largest bank failure in history. The articles estimate that PWC may be responsible for damages totaling hundreds of millions of dollars.

This is an interesting case because the audit firm has had some individuals claim, in court, that auditors are not responsible to detect fraud. The court rejected this claim and said auditors who don't design audits to detect fraud are not following their own auditing standards. Here are some details from the FDIC order related to the case:

“While there are numerous auditing standards that are implicated in this case,...the overarching standard that governed the PWC audits is that: “[t]he auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, whether caused by error or fraud.” AU § 110.02; AU § 316. PCAOB Auditing Standard No. 2 states that “[a]lthough not absolute assurance, reasonable assurance is nevertheless a high level of assurance.” Id. at ¶ 17. To that end, a PCAOB 2007 release clarified that “[t]he auditor should, therefore, assess risks and apply procedures directed specifically to the detection of a material, fraudulent misstatement of the financial statements." (emphasis added). The Engagement Letters between PWC and CBG acknowledged this responsibility by stating that PWC would “design [the] audits to obtain reasonable, but not absolute, assurance of detecting errors or fraud.” See, e.g., A4 at 3. Indeed, Mr. Westbrook, one of the PWC audit partners, testified at trial that PWC had a duty to design audit procedures to detect fraud. Tr. 817:25-818:7 (Westbrook). He further testified that if PWC failed to design its audit procedures to detect fraud, it would be a violation of PCAOB standards. Tr. 822: 19-22 (Westbrook). 

However, PWC voiced a very different tune just a few years ago with respect to another lawsuit that stemmed from this fraud. TBW’s bankruptcy trustee also filed suit against PWC, alleging that PWC breached its duties when it failed to detect the fraud. That lawsuit proceeded to trial in August 2016 before it settled mid-trial. As part of that lawsuit, many of the same PWC engagement partners, audit managers, and audit staff who are involved in this case gave deposition testimony under oath in the TBW trustee’s case. During that testimony, these individuals repeatedly admitted that PWC did not design its audits to detect fraud. For instance, Mr. Westbrook testified that PWC “audits are not designed to detect fraud.” Tr. 358:6-7 (Westbrook) (quoting Westbrook TBW Dep. at 23:7-12). Likewise, Mr. Jackson, the PWC engagement partner, testified that “I would point out that our audit procedures were not designed to detect fraud.” Tr. 1027:1-10 (TBW Dep. at 31:17-20). Similarly, Wes Kelly, PWC’s audit manager for the 2003-2005 and 2008 CBG audits, testified that PWC “did not design audit procedures to detect fraud.” W. Kelly TBW Dep. 45:608 (Ex. P3120). Finally, Mr. Rivers, a PWC audit associate assigned to the CBG audit, testified that PWC had no obligation to look for fraud. Rivers TBW Dep. at 66:17-23. 

At trial, PWC attempted to explain away this testimony by arguing that these individuals simply meant that PWC was not a guarantor against the possibility of material fraud because the auditing standards recognize that “even a properly planned and performed audit may not detect a material misstatement resulting from fraud.” Ex. A400 at 7-8 (AU § 316.12); Tr. 821:25-822:24 (Westbrook stating that in order to provide a guarantee against fraud, auditors would “need a lot more tools like lie detector tests and subpoena power and guns and badges and all those kinds of things.”). This Court does not find this explanation credible, nor is it consistent with the previous testimony from the TBW trustee’s lawsuit. This Court heard Mr. Westbrook and Mr. Rivers testify for hours and is convinced that these gentlemen are more than capable of saying what they mean. If they had intended to say that PWC audits were not a guarantee against the possibility of material fraud, they would have testified accordingly. However, that was not their testimony. Instead, they clearly stated that PWC had no duty to detect fraud and did not design its audits to detect fraud. The Court concludes that PWC did not design its audits to detect fraud and PWC’s failure to do so constitutes a violation of the auditing standards. 

What I find interesting is that practicing auditors admitted that they don’t design their audits to detect fraud even though auditing standards clearly say that auditors are responsible to provide reasonable assurance that there are no material misstatements due to (error or) fraud. Over the past decade, including as recently as 2016, I’ve asked several audiences of auditors to answer the following true-false question: “Auditors have the responsibility to provide reasonable assurance that there are no material misstatements due to fraud.” These auditors range from staff to partners and, on average, about 50% incorrectly answer false. This is pretty disheartening to me...

Unfortunately, my experience suggests that most auditors don’t put in a lot of effort to detect material fraud. Fraud may be discussed briefly in the required brainstorming session but then quickly forgotten as the audit team gets focused on ticking and tying and trying to get some sleep during busy season. 

There are many things that auditors could do but, unfortunately, it's rare to find an auditor who is thinking beyond what they did last year. If I were king for a day, I would require auditors to do interviews with lower level people in an organization with the goal of discovering aggressive accounting or business practices. Combining interviews with strategic reasoning would potentially help auditors provide the reasonable assurance they are responsible for. For example, if strategic reasoning leads the auditors to believe revenue recognition and shipping cutoff is ripe for financial reporting fraud, auditors trained in interviewing could meet with shipping / warehouse personnel about the end of the year. Well designed questions could reveal information that could help identify control weaknesses and potential fraud. 

In any case, this case and other experiences with auditors reminds me of the 1980s when auditors put it in their engagement letters that they weren’t responsible for providing assurance for fraud. Back then, and now, the courts don’t appear to share that view. In the end, both the auditing profession and audit users end up suffering when auditors are weak in fulfilling this responsibility.

Whose Job is it Anyway? Are Auditors Expected to Detect Fraud?

A recent article in The Wall Street Journal details what could be one of the only legal cases from the great recession to actually go to trial. Taylor Bean & Whitaker Mortgage Corp. is suing PriceWaterhouseCoopers LLP (PWC) for $5.5 billion dollars claiming that PWC was negligent in auditing one of their clients. While PWC didn’t audit Taylor Bean, they did audit a bank with which Taylor Bean did frequent business--Colonial Bank (Colonial). Taylor Bean overdrew its accounts with Colonial for several years to cover cash shortfalls, then sold fake pools of mortgages to Colonial in order to cover up the fraud. Taylor Bean claims PWC was negligent in auditing Colonial, and that the collapse of Colonial led to them losing billions of dollars. The real question is how liable should auditors be for detecting fraud?

Another Link Dump

Here are a few more links to keep you up to date on the latest fraud-related news:

A Potentially Costly Combination: Deloitte, Taylor Bean and the PCAOB

If you follow news affecting auditors, you may have noticed that the PCAOB made a very rare disclosure yesterday about one of the big four firms, Deloitte. The PCAOB said that Deloitte was previously sanctioned for not being skeptical enough to challenge statements made by management and that they still have problems with this.

Normally, the PCAOB tells the big audit firms what they did wrong and gives them a year to fix it with the threat that they will disclose their failures after a year if the firm doesn't fix it. Well, they decided Deloitte was still dropping this ball so they disclosed it publicly. Importantly, the timing of this ball dropping may have been very detrimental to Deloitte. Here is why...

An Update on Lehman and EY

According to an article in the Wall Street Journal:

A lawsuit contending that Lehman Brothers Holdings Inc.'s former officials, underwriters and auditors are responsible for investor losses should go forward for the most part, a federal judge ruled Wednesday.

According to the article, the judge ruled that:

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.

Is EY and Lehman a Red Flag for the Auditing Industry?

An article in the Wall Street Journal discusses Cuomo's EY-Lehman fraud case and quotes some very prominent observers of the auditing profession as saying that this is a sign that auditors are not holding the line. To be fair, the article quotes others as saying the profession has been vigilant; I'm hoping they are right! Here are a few key quotes by Lynn Turner and others who believe the profession has let down their guard:

Lehman and EY: Maybe I spoke too soon...

In my Fraud Examination yesterday we talked about how the audit profession appears to have learned from the last economic crisis when it was heavily criticized for inadequate audit work in the frauds that came to light around the turn of the millennium. My comment was that so far, it appears that the fingers of blame for the fiascoes leading to the "Great Recession" were not pointing much toward the audit profession. Some potential exceptions include the Madoff feeder fund audits and the New Century/KPMG situation but I concluded that the auditor finger pointing is not nearly as serious this time as it was at the turn of the millennium.

Today I'm wondering if I should have waited a few hours to make such a comment since a new report was issued about the time I was in class yesterday. This report details the Lehman Brothers collapse and is very critical of EY's audits.

(You can read the 2,200 page report online; I've search for Ernst and found the examiner is very critical of the EY's audits. Also, there are numerous articles about the report and EY's role in the collapse including the WSJ and Huffington Post.)

Suffice it to say that this report says EY failed to meet professional auditing responsibilities. The issue revolves around inappropriate repurchase transactions, known as Repo 105 transactions, used to make Lehman look like it was in better condition than it really was. The report says that Lehman used these Repo 105

... transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality.

Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared...

The examiner alleges that EY was told about concerns that these transactions were inappropriate but they failed to report the concerns to the Board or to adequately investigate the propriety of the transactions.

One of many damaging quotes from the report is:

There are colorable claims against Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.

The report explains:

In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end.

The next day ‐- on June 13, 2008 ‐- Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction from the Committee to advise on all allegations raised by Lee.

Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions.

Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements.

My guess is that now that the report has been out for more than half a day now, 25 or more class action lawsuits have been filed against EY. A report this critical is an invitation to file such lawsuits.

I was hoping that since these particular transactions were not part of last annual audit opinion (since Lehman imploded before the 2008 financial statements were issued), that EY's role may be limited. However, it appears that the transactions date back to the 4th quarter of 2007 and affected the amounts that were audited by EY (see chart at this link). In addition, quarterly 2008 filings that were reviewed by EY were involved. As such, the question to be resolved is what should EY have done when told about these transactions? Apparently, the examiner felt they didn't do their job.

This report is definitely unsettling and the ultimate responsibility of EY in the Lehman situation will likely take months, or even years, to determine. In the meantime, I'll be more careful with my comments about the audit profession's role when the next round of economic turmoil comes to light.

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."

Another guilty plea

Madoff's auditor, David Friehling, operated out of a small office in suburban New York and ran a three-person auditing firm that would be hard pressed to effectively audit anything but the smallest businesses let alone a huge hedge fund! As such, the auditor should have been a huge red flag to anyone investing with Madoff, not to mention regulators.

Today, the 50 year old auditor decided to plead guilty to "securities fraud, investment adviser fraud, making false filings with the Securities and Exchange Commission, and obstructing or impeding the administration of the Internal Revenue laws."

While prosecutors argue that Friehling must have known that Madoff was pulling off the largest Ponzi scheme ever, Friehling is claiming: "At no time was I ever aware Bernard Madoff was engaged in a Ponzi scheme."

Personally, I believe Friehling had no idea that Bernie was committing fraud. However, that does not excuse him from what might be considered constructive fraud and was surely gross negligence on his part. I believe Friehling was so over his head in trying to perform that audit that he should have never taken the engagement. .

No doubt Bernie paid a handsome fee to his auditor just as he did to his investors. Too bad Bernie was giving away other people's money!

PwC now being sued in Madoff case...

Victims in the Madoff case have now expanded their efforts to recover some of their losses by suing PricewaterhouseCoopers. A UK news report states:

The Canadian arm of PwC has been named in seven separate lawsuits claiming as much as $2bn in damages for investors who lost almost everything in the largest fraud in history. PwC Canada was auditor to Fairfield Sentry, the feeder fund that placed $7.2bn of investors' money with Madoff, and which became the biggest single casualty.

At the heart of the suit is the claim that:

As auditors, PwC would have been required to check that the treasury notes existed. However, Madoff was able to conceal any shortfall because he was not just the "execution agent" for Fairfield Sentry's investment strategy but also the custodian of the money. As such, PwC would have received assurances from Madoff that the treasury notes existed.

Investors argue that his dual role should have been a "red flag" that raised suspicions and persuaded the auditors to verify the claim with the US Treasury. Investors also say that Madoff's unusual habit of liquidating the entire Fairfield Sentry investment and converting it into US treasuries for a few days over every financial year-end should have been another "red flag". Since Madoff pleaded guilty to fraud, it has become clear the funds never existed.

This effort to get into PwC's deep pockets followed a similar case where KPMG is being sued for $3.3 billion in the Madoff case for its work on another feeder fund: Tremont Group. I believe BDO Siedman was the first to get sued for its work on a Madoff feeder fund.

My guess is that now that we have two auditors of the feeder funds being sued by Madoff victims that it's only a matter of time before we see more auditor lawsuits related to Madoff.