Will Auditors Become the Next Dismal Scientists?

Since Thomas Malthus predicted the end of mankind as population growth surged, economists have been known as the dismal scientists. (Click here to check out U.S. and global person counts.)

According to "Auditors set for tough talks with clients" by Jennifer Hughes (Financial Times, November 5, 2007), valuation challenges may force accountants to wear the mantle of "life of the party NOT." Though a current focus is on how clients plan to report valuations at year-end, a la FAS 157, auditors must be concerned about ongoing general lack of good process by some reporting entities.

Clients' failure to thoroughly document, and implement, a (hopefully) robust valuation process puts auditors squarely in the litigation crosshairs if they are seen as doing less than a good job of oversight. Though a few years old, the AICPA published a summary of problem areas based on SEC investigations. Four out of five times, the auditor failed "to gather sufficient audit evidence," with countless cases involving "inadequate evidence in areas such as asset valuation, asset ownership and management representations." Click here to access "Top 10 Audit Deficiencies" by Mark S. Beasley, Joseph V. Carcello and Dana R. Hermanson (Journal of Accountancy, April 2001).

It was not too long ago that the U.S. SEC Division of Enforcement and the Office of the Chief Accountant alleged that a CPA "failed to adequately assess the substantial evidence produced by the audits" that there were material "overstatements of the value of convertible bonds and convertible preferred stock." Click here to read the overview.

In "Auditor liability and caps get a hearing in Washington," Financial Week reporter Nicholas Rummell (October 15, 2007) quotes the co-chair of a newly formed committee, Donald Nicolaisen, former chief accountant at the SEC, as saying that "now is the ideal time to look at auditor liability because there is no crisis." Yet the article states that "audit expenses for the largest accounting firms related to litigation and liability had risen to $1.3 billion in 2004, 14.2% of total revenue. In 1999, related expenses were about 7.7% of revenue." (By the way, life sure has changed in the last few weeks as market volatility seems the norm.)

This blog author's take on things is that there will be some "issues" going forward. The math is simple: Investor Losses = Investigation Into What Went Wrong = Blame. While auditors may not be the only ones asked tough questions about oversight, issues abound.

  • How much rigor should be applied by auditors in assessing the mark-to-market (model) process?
  • How do internal auditors treat a lack of independence for those reporting entities that create their own marks in lieu of hiring an outside third party?
  • How many auditors feel comfortable valuing complex derivative instruments?
  • Is statistical sampling of holdings in a large portfolio of "hard to value" instruments considered sufficient?

Stay tuned...


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Pension Risk Matters - August 18, 2008 3:14 PM
According to reporter Doug Halonen, Beantown regulators have launched an inquiry into how corporate plan sponsors value their alternative fund investments. Upset with plans that have no process in place to verify mark-to-model or mark-to-market number...
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