Tejus Trivedi's  Instablog

With Lehman’s ‘Repo 105’ accounting maneuvers going unnoticed for an extended period of time, the most logical next thought is the role that public accounting firms play in a company’s financial statements. Lehman’s examiner put Dick Fuld and Co. (namely Messrs O’Meara, Callan, Lowitt) including Lehman’s public accounting firm, Ernst & Young in the hot seat.

 

The Sarbanes-Oxley Act (2002) was enacted not only to ensure that the CEO and CFO certified as to the state of internal controls within their organization but it also established audit procedures on the public accounting firms themselves. The Public Company Accounting Oversight Board (or PCAOB, sometimes jokingly pronounced "Peek-a-boo") is a private-sector, non-profit corporation created by the Sarbanes-Oxley Act, a 2002 United States federal law, to among other things, oversee the auditors of public companies.

 

The PCAOB carries out inspections on the audit procedures of public accounting firms. The results of these inspections are then published for the consumption of the general public. I thought it would be interesting to highlight some of the ‘issues’ raised by the PCAOB against the big public accounting firms. Unfortunately, companies where such audit inspections have been conducted are not named, but you get a sense of the type of violations committed by these accounting firms.

 

For 2009

 

Deloitte- There were multiple adverse observations but there was one particular observation that related to allowances for loan losses. For one company, Deloitte failed to perform sufficient procedures to test the issuer's allowance for loan losses ("ALL"). This allowance was determined using a quantitative model that was designed to be adjusted for recent conditions and information. During the year, the company gathered evidence of deteriorating conditions relevant to the value of its loan portfolio that were in excess of the ALL. According to the published report, Deloitte “failed to perform a sufficient analysis of whether the deteriorating conditions should have prompted further increases in the qualitative adjustments included in the ALL.” In short what this indicates is that the company might not have adequately provided for potential losses in asset values.

 

Ernst & Young LLP- There were at least two cases where the firm did not perform sufficient procedures to assess the valuation of certain securities. In one of these two cases, PCAOB suggested that insufficient evidence was present to suggest that the firm had sufficiently evaluated the assumptions underlying the company’s valuation of securities. In the other case, Ernst & Young used prices for recent transactions to assess the valuation of the company’s loans. But they did not evaluate whether the loans being valued were of “comparable quality to the loans in the transactions”. And for other other loans, Ernst & Young developed an independent estimate of the value. But such an estimate was based on an incorrect assumption that transactions whose inputs were used were in fact comparable to loan transactions that were being valued. In a third case, the firm failed to perform adequate audit procedures beyond “management inquiries” in estimating the fair value of certain assets that collateralized loans.

 

What is most alarming is the fact that many of these findings relate to loan allowances or valuations of collateralized assets. Material mistakes here could potentially spell disaster.

 

Each of the other large public accounting firms were also inspected by the PCAOB. If you are interested in the whole list, click here.

 

Unfortunately, certain parts of the report are kept private and are not published. These include the results of an inspection of the audit firms’ quality control system which in fact would be critical to understanding the quality of their audits at large companies. It could also indicate the extent to which reliance could be placed on their audit conclusions.

 

As an offshoot of this research, I thought it would be interesting to take a quick look at how audit fees at the 6 largest banks’ have fared over the past 3 years, starting with 2007.

 

Audit fees average in the $20-$60 million category. At the highest end is $128 million paid by Bank of America to PricewaterhouseCoopers (PwC) for 2009. In 2007, they were paid $61 million. At the lowest end of the spectrum is Goldman Sachs with $38 million paid to PwC for 2008. 2009 figures are not yet available. Most notable is the absence of Ernst & Young (E&Y). It appears that none of the large 6 banks have E&Y as their public accounting firm of choice. Ernst & Young was Lehman’s public accounting firm until its demise in September 2008.

 

It is interesting to note that public accounting seems to be one profession that, recession or not, appears to be doing very well. Where else would you find such a quick and steep jump in revenues despite the fact that your customers are not doing well financially?

 

What is most concerning is whether the inspection reports published by the PCAOB are even read by shareholders or presented to the Board of Directors. As per most Board Audit Committee charters, public accounting firms are expected to present results of the review of their quality control systems to members of their client company’s Audit Committee. But whether this is actually done or not, is difficult to determine given the opacity of reports published by the companies themselves.

 

From the time we started presenting InvesGuard’s scores on the non financial metrics of public companies, Citigroup has been our ‘poster boy’ for poor corporate governance. Click Sample (Citigroup) to see its scores as they stood in April 2009. Overstretched directors (2 directors were held 4 public company directorships. 3 out of 14 directors were CEO’s of other public companies.) and ill suited directors were the top concerns at Citigroup then.

 

 

In addition, InvesGuard also scrutinizes experience and backgrounds of directors especially in the case of financial and banking companies in order to ensure suitability for the Audit, Risk, Credit and other ‘finance centric’ Board Committees. In this area too, Citigroup as it stood in April 2009 left something to be desired. 2 out of 5 directors on the Board’s Audit and Risk Management appeared to lack experience that could be considered essential to providing audit, financial and risk management oversight specific to a company in the financial industry.

 

 

As a result of recent changes in the composition of the Board’s Audit committee, all directors on this committee now have relevant and adequate financial industry experience. In addition, Citi has now created a separate Board level Risk Management committee. The primary aim of this committee is to provide ‘oversight of Citigroup’s risk management framework’. Of course, only time will tell whether the members of this Board committee have been performing their job adequately.

 

 

CEO Vikram Pandit’s testimony before the Congressional Oversight Panel on March 4, 2010 attributed ‘questions about the Bank's financial condition’ to the ‘quality of some of our assets’. Previously, oversight of asset quality was not within the purview of any Board Committee. With changes to Citigroup’s overall Board composition and structure, the newly formed Citi Holdings Oversight Committee is tasked with the responsibility to oversee the management of ‘the special Asset Pool (including assets covered by the loss-sharing agreement with the U.S. Government). Another new Board Committee which is the Risk Management and Finance Board Committee now responsible for "oversight of Citgroup’s risk management framework, including the significant policies, procedures and practices used in managing credit, market and other risks…..” Although both these committees do not directly cover areas such as oversight of the adequacy of allowances for loan and lease losses and related written policies and procedures, yet the enhanced oversight measures provide some degree of comfort. Again, with the changes in Board composition, both these committees are staffed with directors with previous banking and financial industry experience. Last week, we blogged about Lehman’s poor choice of directors. Directors with zero financial management or banking background were in charge of providing risk management oversight.

 

 

By installing directors with more relevant experience, Citigroup has taken a step in the right direction. Let’s hope these steps keep it on the right path.

 

 

Disclosure: "No Positions"

Quick update from the bankruptcy courts vis-a-vis Lehman Brothers. The report turned in by the examiner appointed by the court covers 3 broad areas-

 1.Why did Lehman Fail?

 2.Are there valid claims for preferences or voidable transfers?

 3. Are there valid claims arising out of the Barclays transaction?

The most relevant aspect from a Governance standpoint was the section that tried to understand the role (or lack thereof) that Lehman directors played in the entire Lehman failure.

 According to the report,

 " The Examiner Does Not Find Colorable Claims That Lehman’s Directors Breached Their Fiduciary Duty by Failing to Monitor Lehman’s Risk‐Taking Activities "

 Lets take a step back, in fact, lets take several steps back to 2008 when Lehman filed its proxy statement.

 Here is a list of Lehman directors who made up their Board Finance and Risk Committee and their corresponding 'relevant' experience.

 1. JOHN F. AKERS- Retired chairman of IBM (retired in 1993), also formerly on the board of the Metropolitan Museum of Art.

 2. ROGER S. BERLIND- Theatrical Producer

 3. MARSHA JOHNSON EVANS-Former CEO American Red Cross and former executive director of Girls Scouts as well as a retired naval admiral.

 4. ROLAND A. HERNANDEZ-Former CEO of Spanish Language Television Station

 5. HENRY KAUFMAN- President of Henry Kaufman & Company, Inc., an investment management and economic and financial consulting firm.

 According to Lehman's Finance and Risk committee charter, members were required to "review(s) and advise(s) the Board of Directors on the financial policies and practices of the Company, including risk management. The Finance Committee also periodically reviews, among other things, budget, capital and funding plans and recommends a dividend policy and Common Stock repurchase plan to the Board of Directors."

 Which of these 5 directors you think would be able to provide oversight over Lehman Brothers' Risk Management practices? The 'girl scout' perhaps or maybe even the 'theatrical producer'?

 I think even for the most basic and junior level job, most hiring managers will ensure that incumbents have relevant experience....and these were senior oversight positions with a company that were filled in by persons with great but irrelevant experience.

 Now that we know that Lehman had such 'illustrious' and highly 'accomplished' directors on their Board Finance and Risk Committee, was Lehman's failure just a matter of time?

 The clean chit given by the Court appointed examiner to Lehman's Directors is a slap in the face for corporate governance.

 Anyway, for those interested, InvesGuard regularly tracks this data for all companies. We have put a few reports out there that outline this and many other non financial metrics.

Disclosure: None