How much of it is bollocks?

[peterbirks]

If a gun were put to your head, what percentage would you say of the gross "profits" since the year 2000 will eventually turn out to be fictitious?

This is no mere angels on the head of a pin question. If we knew this number for certain, then we have some idea of how much money has been lost to the real economy that the accountants asured us we really had. Of course, it doesn't include the more significant sum that is future losses caused by a recession, but it's a useful number nevertheless. It's a lot easier to forecast the future if you know what has actually happened in the recent past.

After the Madoff $50bn scandal, we now have the Satyam $1bn scandal (well, let's call it $1bn-plus). The chairman of the Indian outsourcing company confessed he had invented fictitious cash and bank balances worth $1bn. Ramalinga Raju (winner, Ernst & Young India Entrepreneur of the Year Award) made up sales and profits to make the margins look better. I eagerly anticipate PricewaterhouseCoopers' doubtless exceedingly logical explanation of how they, as auditors weren't in any way to blame for failing to uncover this.

What it means is that auditors' signing-off only protects you against the most basic stuff. Any deliberate deception by a team of senior managers will fool any auditor and any regulator without much difficulty, for the simple reason that people in business tend to be smarter than the people policiing the business.

Corporate governance is an important area and is one not often mentioned by those recommending investment in emerging markets. At least if you invest in UK and US listed operations, you have a better chance of finding out what is going on, and it is rather harder to run massive frauds along the lines that can be achieved in the listed emergeging market companies or in the unlisted US/UK sector.

Where the problems arise is if a listed US company has a subsidiary that operates elsewhere (see, AIG Financial Products). The opacity of some financial services companies' accounts is frightening, because inconvenient stuff can be listed (but not explained) under those subsidiary numbers. Fairfax, Mapfre and Swiss Re have all had me tearing my hair out at the complexity of their subsidiary operations, and these are the more highly regarded operations. The ones in which I have less faith (names withheld because I quite like the idea of staying alive) just defy belief.

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Comments

[simonbillenness.livejournal.com]

Don't opaque conglomerates tend to be marked down by analysts and therefore the market?

Smart investors avoid companies that they don't understand. Warren Buffett avoided the Internet crash of 2000 because he could not understand the business model of the new web companies. Smart investors know what they don't know and stick to what they do know.

He does, by his own admission, sometimes make wrong decisions, such as investing in the airlines a decade or so ago. But his investment approach has generated impressive, steady returns.

I would assert that it is not necessarily incompetence amongst auditors and regulators that allows fraud to remain uncovered. There are a number of times when analysts or auditors have tried to sound the alarm.

What can often undercut the whistle-blowers is conflict of interest. Banks have curbed criticism by their analysts to protect their lucrative corporate lending and underwriting business. Regulators are clipped by politicians who receive corporate donations.

comment

[(Anonymous)]

"Any deliberate deception by a team of senior managers will fool any auditor and any regulator without much difficulty, for the simple reason that people in business tend to be smarter than the people policiing the business."

This comment shows a classic misunderstanding of fraud or deception and the inherent limitations in the auditing role. Auditors must rely on the management not to be deceptive or fraudulent. If the people supplying the information to Einstein, who he believes are not lying, are lying, how is Einstein ever to know the infromation is wrong. the problem is that auditors must rely on their judgement to whether or not management is trustworthy. If they ask for back up to expenses and assets and the material is provided by a false "third party" there comes a point where there is no way to discover fraud by top management. Fraud by low management or adminstrative people is more easily found because they cannot control all of the information that is being supplied.
To say that people in my professional are less intelligent than the people whose businesses we audit is false, we just have different skill sets, and a lot of our professionals become business owners and leaders. I have many clients who couldnt add their way out of child's book, but thankfully, they are just architects.

Re: comment

[peterbirks.livejournal.com]

1) I did not say that auditors and regulators were less intelligent than people in senior management. I said that they tended to be. It's a point I stand by, having met regulators/auditors and people running businesses.

2) If it's a "classic misunderstanding" you should question why that misunderstanding is there.

3) "Auditors must rely on the management not to be deceptive or fraudulent". How, then, can auditors ever be found to be at fault, unless they simply add up two columns of numbers incorrectly? I've heard this crap from people at PwC, KPMG and Ernst & Young before. It isn't true.

The job of an auditor is not just to follow a strict set of rules when examining the books. It is also "to interview employees and managers of companies and corporations to determine that their statements match up with the financial records of the company". Now, if all of these people are very good liars, and they make consistent statements (that later turn out to be false) then I'll accept some kind of mitigating excuse on the part of the auditors. And, indeed, this is usually the excuse put forward by auditing mouthpieces (such as yourself).

But when you get cases such as FAI (In Australia) and Independent Insurance (in the UK), where any diligent examination of books and questioning of employees and managers could not have failed to have uncovered flaws, then it is quite clear that the auditors were either (a) stupider than Michael Bright (in the case of Independent Insurance) or (b) happy to take Mr Bright's largesse and payments and not look too closely at underlying matters.

Indeed, I've just checked this up, and I see that KPMG were fined £495k for this, with the individual employee concerned being fined five grand. The Joint Disciplinary Service found that Independent's statements should have caused "obvious suspicion".

These are not isolated incidents. In nearly every case where a company has collapsed through deception in the financial services industry, the people doing the books should have raised alarm bells earlier than they did. What are you going to do next -- defend Bernard Madoff's auditor? In that case the hardest thing that the guy would needed to do would have been to ask to see the numbers of the bonds being held (Madoff listed the same numbered bonds in many different places). Or what about Satyam? All that the auditor needed to do there would have been to check that a bank account existed. What about Robert Maxwell? Here the auditors were cowed by Maxwell's overbearing manner, despite the fact that the financial shenanighans at the Maxwell House stank to high heaven.

These cases either displayed a lack of brainppower or a lack of diligence.