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How The Blame Game Has Shifted To The Auditors

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Article written on December, 01, 2012 by Kyran Fitzgerald

Auditors are coming under the spotlight for all the wrong reasons and it appears that the profession’s public role of giving a ‘true and fair’ view of the state of a company’s finances is far from straightforward, writes Kyran Fitzgerald

It used to be that if you needed a boring, reliable guy around the place you phoned for an auditor. These days, it seems, the sheriff is regularly getting up a posse and hunting such characters down.

For legal actions against firms of auditors come thick and fast, these days.

This week, the Irish Bank Resolution Corporation, in what has been described as a watershed moment in the country’s banking crisis, announced that its lawyers, McCanns Solicitors, would be serving legal papers on Ernst & Young, one of Ireland’s Big Four accountancy practices.

In what could best be described as a busy period for Ernst & Young, it also finds itself potentially embroiled in legal proceedings being brought by Hewlett Packard (HP) against Mike Lynch, the Irish born owner of British software group, Autonomy, which HP acquired just over a year ago for £11bn.

HP recently announced it is writing off more than £5bn in respect of the purchase and has alleged “serious accounting improprieties, misrepresentation and disclosure failures”.

The allegations have been vigorously rebutted by Mr Lynch, needless to say.

Among the allegations levelled by HP and its CEO Meg Whitman — that future revenues from software subscriptions were booked all at once in order to put a favourable gloss on things. Mr Lynch has fiercely denied the claims

All Big Four firms are embroiled in the ‘Autonomy’ affair, with potentially huge ramifications.

Deloitte & Touche served as auditors to Autonomy — they will be questioned on their failure to check under the financial floorboards.

Ernst & Young are HP’s auditors. They would have reviewed HP’s financial statements and have given assurances that they were not aware of any material modifications to accounts.

The public role of the auditor, the solemn swearing at the annual general meeting that the accounts as signed “give a true and fair view” of the state of the company finances, is or should be the tip of the iceberg. A good auditor should be able to sniff any rot that lurks beneath the rows of figures.

But faced with clients determined to hide unpleasant matters, this task is by no means straightforward.

In their dealings with Sean FitzPatrick, David Drumm and others, Ernst & Young, clearly failed to spot rather a lot — however, the task of establishing culpability may be anything but straightforward. This may explain why the IBRC charged with the task of winding down Anglo Irish Bank (and of course, Irish Nationwide) has waited so long, until close to the end of the statutory limitation period for many civil actions, before pressing the legal starting gun.

Clearly shareholders who relied on the auditor’s assurances when purchasing their once high flying, but eventually worthless Anglo shares will be studying events closely, among them the currently incarcerated Seán Quinn.

Ten years ago, one of the Big Five accountancy firms, Arthur Andersen, was dissolved as a global partnership in the wake of the collapse into bankruptcy of the Texas energy trading group, Enron. The $63bn collapse was the largest in US corporate history at the time.

One conclusion was that Enron’s auditors, Andersens, allowed themselves to become excessively intertwined with their client, leading to a situation where it lacked the necessary independence to fulfil its role as auditor. Arthur Andersen and some of its US partners were later convicted of obstruction of justice.

But the Enron-Andersen was the culmination of a long drawn-out process of change in the accountancy profession.

In North America and in Western Europe, the profession became increasingly consolidated and as the large firms emerged, the role of the audit gradually changed.

Audit work became increasingly commoditised and audits came to be used as a means of hoovering up more lucrative business.

Clients increasingly shopped around among firms and the less scrupulous placed subtle pressure on the audit firms, making it clear that firms which adopted a particularly flexible approach would be most likely to bag the audits and by extension, more lucrative tax and consultancy business.

The Enron saga led to much tighter rules in the form of the Sarbanes Oxley Act in the US. The law aimed to boost the independence of auditors.

However, in the lending bubble that followed in the US and much of Europe the degree to which auditors retained independence respect is questionable.

What is certainly the case if that the leading Irish accounting firms remain busy and apparently profitable in the face of the recession, though with income levels around one fifth lower than at the peak of the bubble.

Finance magazine reported that total fee income of €1.071bn was earned in 2011 by the top 20 accountancy firms.

Ernst & Young was in fourth place with €125m — a rise of 5% to €130m in its latest financial year ended July 31 has just been reported.

Global revenues at Ernst & Young reached $24.4bn in the year to the end of June 30, a rise of 7.6% on 2011.

Clearly, accounting remains recession-proof and it remains the case that most parents smile when their daughter brings home a young male accountant to meet the family.

Indeed, some of the firms have been expanding. Ernst & Young has just announced another 30 senior managerial hires, having previously filled 300 posts.

In the words of managing partner Mike McKerr “we have had a good year in challenging times”.

Now, times look set to get even more challenging.

Shareholders in failed Irish banks, not to mention the taxpayer, will, no doubt, be anticipating a court joust involving the auditors of Anglo which will run in parallel to the proceedings being brought against the top executives of Anglo before its collapse.

But anyone who thinks that the law suit against Ernst & Young will be a “slam dunk” might have to think again.

In the US, the New York financial regulators have brought legal proceedings against — guess — Ernst & Young, to recover $150m in fees earned between 2001 and 2008 when the firm was acting as auditors to Lehman Bros, the investment bank whose September 2008 collapse triggered the global meltdown.

The audit firm has been accused of “financial gimmickry”.

Ernst & Young promised a vigorous defence.

The law suit follows hot on the heels of proceedings brought against KPMG, auditors of failed subprime lender, New Century.

The case against Ernst & Young in Lehman is one of the biggest involving anaccountancy firm since Enron. The case was heard by a well known Federal Judge, Lewis Kaplan in July 2011.

While Kaplan sustained certain allegations against the firm, he was not able to really throw the book at Ernst & Young due to the fact that the requirements of the company as auditor were vague and allowed scope for subjectivity.

Such lack of clarity when it comes to the duties on auditors could also play a significant part in affecting the outcome of the proceedings being brought by IBRC. We have yet to see the statement of claim so IBRC has yet to reveal its hand of cards.

As commentators have noted, the obligation in Irish companies law on auditors to give a true and fair view is qualified by a softer requirement that it be in accordance with existing financial reporting frameworks.

The strength of suchreporting requirements in the run up to the crisis left much to be desired.

However, the courts contain some pretty capable and clear thinking individuals. It is likely that the hearing of this action may contain a lot more matters of interest than your average audit report.