Accountants failed again in the financial crisis

A U.S. Senate subcommittee held a hearing April 6 on “The role of the accounting profession in preventing another financial crisis,” and hardly anyone paid attention, probably because no one believes accountants are financial watchdogs anymore.

Certainly they don’t seem to have warned about the build-up of leverage on the repurchase market that  led to the panic of 2007-2008.

Two witnesses at the hearing laid into the profession, however, and their testimony deserves review: James R. Doty, chairman of the Public Company Accounting Oversight Board, and Lynn E. Turner, former chief accountant of the U.S. Securities and Exchange Commission.

The Public Company Accounting Oversight Board is an SEC agency set up by the Sarbanes-Oxley Act of 2002 in the wake of the Enron scandal to “oversee the audits of public companies in order to protect investors and the public interest by promoting informative, accurate, and independent audit reports.”

From Tom Selling’s Accounting Onion blog:

The most telling moment of the hearing was Doty’s unequivocal acknowledgement that auditors should have delved deeper into valuation, going concern and end-of-period issues before issuing their clean opinions on financial institutions that ultimately disintegrated in one way or another.

From Doty’s testimony, “The watchdog that didn’t bark … again”:

The recent financial crisis presented auditors, and by extension the Sarbanes-Oxley Act audit reforms, with their first big test since these reforms were put into place. By any objective measure, they failed that test.

Dozens of the world’s leading financial institutions failed, were sold in fire sales, or were prevented from failing only through a massive government intervention – all without a hint of advance warning on their financial statements that anything might be amiss.

Investors suffered devastating losses. Millions of Americans lost their homes or their jobs, and $11 trillion in household wealth has vanished, according to the Financial Crisis Inquiry Commission.

As a result, serious questions have been raised both about the quality of these financial institutions’ financial reporting practices and about the quality of audits that permitted those reporting practices to go unchecked.

Roughly a decade ago, a series of massive corporate accounting scandals at some of the nation’s most respected public companies rocked the markets, costing investors trillions of dollars in lost market value and leading to passage in 2002 of sweeping legislation to restore integrity to public company financial reporting practices and reliability to public company audits.

Central to the legislation were provisions to:
– Enhance auditor independence with an eye toward making auditors more willing to stand up to clients and insist on accurate financial reporting
– Create an independent audit oversight board responsible for raising audit standards and holding auditors accountable for meeting those standards

The common goal of these provisions was to restore auditors’ credibility as public watchdogs dedicated to ensuring the accurate financial reporting on which the integrity and stability of the capital markets depend.

While auditors did not cause the financial crisis, it is difficult to look at the list of failed institutions that received an unqualified audit just months before they failed and conclude that auditors didn’t play a role.

For example:
– Did auditors’ failure to adequately test or challenge company valuation methods allow companies to hide their deteriorating financial condition from investors and regulators alike?
– Did auditors inappropriately allow companies to hide risks off-balance-sheet when the company remained exposed to the risks?
– Did auditors inappropriately agree to, or even help design, transactions whose sole purpose was to hide from investors the degree of leverage or other risks the company had taken on?

If the answer to these questions is yes, these practices not only deprived investors of important information, they encouraged companies to take on risks they might have avoided if those risks were required to be fully disclosed, and contributed to the freezing of the credit markets once the crisis struck.

Since the crisis, there have been no major enforcement actions againt auditors by the SEC or the Public Company Accounting Oversight Board, and Congress has been silent except to pass bills that further weaken accounting standards, Doty said.

From the Accounting Onion:

Nothing less than a fundamental reassessment of the role of auditing in public company financial reporting can begin to accomplish what is needed after the three auditing Armageddons in three decades: the S&L crisis, Enron et al, and the 2008 financial crisis.