Unlike what many people think, most of the time, auditors were not tasked with detecting fraud. Even with such a low standard, the “Big 4” accounting firms, considered the “best,” have consistently received fines for negligence and misconduct. How can investors safeguard their investments?
I recently talked with a fellow investor about a fund with numerous potential red flags of fraud (such as deceptive advertising and the sponsor’s refusal to release standard financial information to investors). He told me, “I don’t have to worry about fraud because they’re audited by (anonymous Big 4 accounting firm).”
It’s very typical to think in that way. Unfortunately, it has two significant flaws.
Oh, haha. Were you anticipating I would use that audit to look for “fraud”?
Most people in the general public will affirm that an audit’s primary goal is to uncover fraud. Sadly, this *isn’t true*. The “low bar” that auditors “simply” set for themselves is a “pass or fail ‘opinion’ on whether financial statements obey accounting rules, as The Economist puts it.
Even though there is an amount of fraud investigation, it is not thorough. Instead, the audit “opinion” is based solely on the auditor’s examination of a small sample of the transactions. As a result, the word “fraud” isn’t even mentioned in the standard auditing statement. Furthermore, if and when the audited company commits fraud, the accounting firm will always claim that it is not to blame, even if it had a material impact.
Vernon Soare, Chief Operating Officer of the Chartered Accountants Institute, stated that there is no guarantee that there are no material errors. It is evident whether it is brought on by error or fraud because auditors do not examine every transaction and event. According to company law, an audit “is not there primarily to find a copy; the auditors provide only an accurate and fair opinion of the company’s accounts.
“How come we paid for that audit?”
Accounting Professor Emeritus at the University of Illinois, Andrew Bailey, has a harsh reaction to this kind of disregard on the part of the accounting profession.
According to Bailey, it is unclear what value-added service the auditor provides to investors and capital markets. Detecting significant fraud and mistakes is not a substantial part of the audit’s focus.
A very polite way of saying, “why are we paying you?”
But the industry has so far been resistant to change.
Sadly, structural conflicts of interest make the issues worse. The companies that audit are supposed to be overseeing pay the auditing firms, not investors. And a company that conducts a successful audit can anticipate keeping an auditing position for decades (the same firm has audited 85% of the S&P 500 companies for over ten years). It makes sense why the watchdogs lack teeth (we’ll get to that in a moment). However, the current trend is likely toward deregulation and reducing the requirements placed on accounting firms. Investors must protect themselves because the situation is unlikely to change anytime soon.
The Big 4 are different, though, right?!!
Even after learning about some auditing limitations, many people still think that the more significant accounting firms are immune to these issues. There have undoubtedly been smaller businesses implicated in accounting scandals. The Big 4 have also experienced their fair share of scandals, though. Several audits for which the business had committed severe material investor fraud were approved. The Big 4 were frequently fined or criticized for failing to meet the minimal standards of the current fraud-sampling regulations. In one instance (KPMG), several principals were charged with trying to influence how regulators double-checked their audits.
“I appreciate the audit, but who is auditing you?”
For example
1. EY (Ernst & Young):
· Weatherford International Scandal: The Securities and Exchange Commission (SEC) fined Ernst & Young $11.8 million in 2016 for failing to detect a company fraud over four years. Weatherford International was fined $140 million for fundamental errors made by EY. It includes “relying on Weatherford’s unsubstantiated explanations instead of performing the required audit procedures to scrutinize the company’s accounting.” They also discovered that EY “did not take effective measures to minimize known recurring problems its audit teams experienced when auditing tax accounting.”
· Reprimanded: The UK accounting watchdog censured Deloitte for producing audits that needed “significant improvement” and “lagging behind their professional services peers in terms of the quality” in June 2017.
2. KPMG:
· Rolls-Royce scandal: The US Department of Justice ultimately fined Rolls-Royce more than $862.8 million in January 2017, even as KPMG served as the company’s auditor. (as well as UK and Brazil accounting fraud agencies). There were claims that Rolls-Royce was involved in lengthy accounting fraud and bribery scandals (during which time KPMG was an auditor and did not detect it).
· Reprimanded: By producing audits that required “significant improvement” and “lagging behind their professional services peers in terms of the quality,” KPMG was criticized by the UK accounting watchdog in June 2017.
· Indicted: The Securities and Exchange Commission (SEC) indicted five KPMG principals in January 2018 on charges of conspiring and attempting to thwart government reviews of their audits. The SED fined KPMG $50 million in June 2019 for engaging in behavior that was, in its words, “astounding.”
3. Deloitte:
· Aero scandal: Deloitte was fined £4 million for its audits of the Aim-listed Aero in November 2017.
· Reprimanded: The UK accounting watchdog censured Deloitte for producing audits that needed “significant improvement” and “lagging behind their professional services peers in terms of the quality” in June 2017.
4. PwC (Price Waterhouse Coopers)
• Connaught scandal: cost Price Waterhouse Coopers a record £5 million in fines for
“misconduct” in connection with its audit of the Connaught social housing organization.
• Colonial Bank Scandal: The court determined that PwC was careless in spotting the fraud that led to the bank’s collapse.
These are how the allegedly most reliable “cream of the crop” firms have been performing in audit quality. The industry, in my opinion, has a severe issue.
Is an audit therefore useless?
It might seem like a waste of time and resources to conduct an audit in light of all the fraud. Undoubtedly, some disagree with that.
They still have some use, in my opinion. Although an auditor only examines a small sample, I contend it is still better than nothing. Additionally, it can be beneficial when auditors do uncover fraud.
However, I also don’t rely on an audit to prevent fraud. In my opinion, all other fraud checks, such as in-depth “Death by Google” investigations, customer and supplier reference checks, and personal background checks on principals, should still be conducted (See how I do due diligence on a deal).
When I discover a red flag, it can be an easy pass on the deal. Sometimes, however, there may be a suspicious cluster of numerous yellow flags. In that situation, I typically still do. Possible mitigating factors exist (and everyone will always explain). However, I also have hundreds of deals to choose from each month and no red flags of fraud. Therefore, why chance it on a potentially suspect person? I just proceeded to the following transaction.
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