Tuesday, November 11, 2008

Auditor's to blame for unreliable financial statements?

It can be safe to conclude that the recent financial crisis can be largely attributed to loose or missing internal controls coupled with a lack of adequate regualtion at large public companies. To guard against the lack of controls and regulation affecting the reliability of financial statements, these financial statements are certified as being 'true & fair' by 'independent', qualified and trusted public accounting firms.

Auditor processes and procedures at various public companies undergo an indepth scrutiny by the PCAOB (Public Company Accounting Oversight Board). This is a private body that was established by the Sarbanes Oxley Act, 2002 with a mission to keep an eye on public company auditors.

Unfortunately, the number of cases where the auditors have been reported to have failed in their responsibilities is growing at an alarming rate. 2 recent cases related to the incompetence of senior executives of Deloitte were recently brought to light. Both these executives were partners at the Chicago office of Deloitte.

In one case, the Deloitte partner Christopher E. Anderson, showed gross negligence by ignoring 'apparent errors' in financial statements resulting in an overstatement of earnings, assets and revenues.

In the other case, the Deloitte partner, Thomas Flanagan used his information about the financial and non financial aspects of his client company to profit from trading in that company's securities, sort of like 'insider trading. This breaks the SEC's rule regarding 'independence' requirements for auditors. This was not a one time or one client incident. He did this over a period of 3 years and for all the clients where he was the engagement partner (including Walgreens, AllState and USG Corp). Consequently, the reliability of all those financial statements where he signed off comes into question. Walgreens, Allstate and USG subsequently conducted a legal investigation and concluded that their annual and quarterly financial reports were unhindered by the Deloitte Partner's activities. (How is that possible?!!)

This is just the tip of the iceberg. The PCAOB publishes the results of the inspections of such accounting firms here. I have to warn you that this is by no means a small list....My suggestion would be to find out who is the auditor of the company that you are invested in, ( you will get this from the company's annual report, if you cannot find it, send me a message and i will get you the name) and find out if this auditor is on the PCAOB inspection list. (the probability that they are on this list is very high.) You can read the inspection report to find out which company and what matters were raised during the inspection. Granted that these inspection reports cite historical cases, but knowing who is certifying the financial statements of the companies that you are invested in, is a key piece of information. This is definitely some useful reference reading that every investor should use.

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