On Audits and Auditors

by: John M. Mason

I would like to recommend the column by Jennifer Hughes in the Financial Times this morning. The title of the article is “Lehman Case Revives Dark Memories of Enron.”

The issue at hand is the relationship between a firm and its external auditors. The reason for the attention given to this issue by Hughes is the examination of the collapse of Lehman Brothers by Anton Valukas. Although not a major thrust of the review, questions did arise in the study concerning the role of Lehman’s external auditor Ernst & Young in the accounting practices adopted by the firm.

Ernst & Young began auditing Lehman Brothers in 1994 and two of Lehman's Chief Financial Officers came from this external auditor. One, David Goldfarb, joined Lehman in 1993 and became CFO of the firm in 2000. The other, Chris O’Meara, joined Lehman in 1994 and was the CFO from 2004 to 2007. It was under Goldfarb that the accounting policy with respect to “Repo 105” transactions was developed.

To Hughes, this brought up memories of the accounting relationship between Enron and the external auditing firm Arthur Andersen. Again, a very close relationship had been established between the two organizations and many Andersen staff worked for Enron over the years.

I am not out to just criticize the accounting profession and the good and proper working relations that exist between many companies and their external auditors. However, the relationship between companies and their auditors can become too cozy and can present the opportunity to do things with company books that are, let’s say, not quite what the owners would like them to pursue.

My interest in this relationship comes from my experience as a senior executive, including President and CEO, of several publically traded banking companies. Each case was a turnaround situation.

In such a situation it is vital to get the accounting books in order and presentable to shareholders and the investment community for their close scrutiny. Internally, it is good to have “fresh eyes” to perform such a review. In a troubled institution it is problematic to have the same people, from inside as well as from outside the organization, performing this exercise. The first reason for this, of course, is that these same people watched the organization become troubled and they have a self-interest in defending the status quo. This is neither good for the company nor the shareholders and, thus, certainly not good for the executives hoping to turn around the firm.

But, this pointed me to the problem that the financial controls that had existed were not sufficient for the company or for the executives in charge to prevent the firm from collapsing into a troubled institution. So, either the work was not getting done adequately or the executives that had been in charge did not want the work to get done adequately. Either way, the situation was not a good one for the institution or the shareholders.

It became my rule that any organization in which I was the CEO would put the job of external auditor out for bids in the fifth year of an engagement. I felt this was necessary for me to keep on top of what was going on in the organization and to have “fresh eyes” review the books and the accounting procedures on a regular basis. Furthermore, doing this periodically encouraged the openness and transparency on the part of the employees that I believed was necessary for the shareholders and the investment community.

This “rule” of mine may have been a little severe, but I was doing turnarounds at that time and the tighter time schedule seemed important to me then. Perhaps a seven year turnover of external accountants would be better, except in cases where the CFO of the company happens to be a former employee of the accounting firm doing the external auditing.

Hughes mentions in her article that Italy, among other countries, has limits on audit firm tenure. There the length of time allowed is nine years. Other countries require that the “lead partner” from the accounting firm be changed every five years. Also, there are rules about hiring individuals from the external auditing firm, rules that require a “cooling off” period for anyone joining an audit client.

To me, this requirement seems of particular importance to banks and other financial institutions. Yes, the banks are examined by the regulators and this should provide a check on what banks are doing. But, this is not enough in my mind.

When I was a bank President and CEO, I wanted the bank to have stricter requirements on what it did than the regulators. The reason is that I wanted the company to control the position of the bank and not the regulators. This also applied to the safety and soundness of the bank. That is why I wanted to ensure that the external auditors were truly independent of me and the staff of the bank. Having the external auditor “turnover” on a regular basis was one way to help achieve this goal. To my mind, any CEO that has the best interests of his/her shareholders in mind would want this to be the case.

I know that this is not the case of all CEOs in all industries. That is why some regulation of company/external auditor relationships is important. This is true especially for the commercial banking industry. Any regulatory reform that is passed should have some statement about the presence of an external auditor and the regular replacement of external auditors. This is a first round effort to insure the safety and soundness of the banking system and should, if it existed, ease some of the burden placed on the examination efforts of the regulatory agencies. It is a part of the openness and transparency that should be required for all companies, but especially for those related to banking.

I know that there is little academic research, as Hughes reports, connecting “audit, or auditor tenure, and the quality of the work.” I know that most situations and people work out well. I know the value that hiring someone familiar with your books is a “good thing” because of the complexity and sophistication of accounting practices today.

Still, I always wanted to be on top of things and continually have “fresh eyes” looking over the operations and the books. I always wanted to be challenged to do things in the best way possible. I always wanted people to push me to do better. Openness and transparency never bothered me. To me, performance always went back to how well you executed your game plan and not on how much trickery or deception you needed to win.

To me, it all comes back to fundamentals and ability. If you lack one or the other or both…I guess you need to rely on other means, like “cooking the books,” to come out on top.