Big (Four) Trouble in Little China – and Middle America

Nick is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

CPA and Big Four survivor Francine McKenna uncovers the games multinational accountants play in her regular Forbes column, Accounting Watchdog and on her indispensable blog re: The Auditors.  Her diligence often illustrates that what investors find so egregious in other countries’ financial markets not only can impact Americans, but is also taking place in the US as well – courtesy of the global auditing firms.

[continued fromThe Long-Term Value of Short Sellers”] 

Slepko:  Setting recent upheavals in China aside, in general, can the individual investor trust the numbers they read in a public company’s annual report if they are approved by a Big Four auditing firm?

McKenna:  No.

Slepko:  Aren’t the auditors the friend of the investor?  Aren’t the auditors just victims of an overly complicated regulatory system?

McKenna:  Ideally (and idealistically), the auditor has a public duty to the shareholder, via a government franchise granted as a result of the mandate for an audit of every public company.  What has happened is that the auditing has transformed from a professional partnership with those ideals into a corporate style business.  What they are interested now is doing business – and re-growing their consulting practices.  So, an auditor’s alignment is now much closer to the corporate executive than the individual investor – because that’s who pays their bills.  Like the CEO, former CEOs, and other directors, they have come to believe things like activist investors are difficult and problematic.  They are much more interested in keeping their fees down for the sake of the long-term relationship.  It’s all very mercenary.  Auditors have really abandoned the investors.

The audit has deteriorated into a stamp of approval, and the auditors themselves say that the audit is not designed to detect fraud and they aren’t willing to put in the time and the resources, nor are the companies interested in paying them to do that.  

We can hold them responsible through lawsuits, but it’s not easy, though it has been more successful in recent years.  The bottom line is that serious investors need to do their own due diligence and perhaps realize that even if a company has a Big Four auditing firm that their numbers should still be reviewed and critiqued.

In particular, this problem has arisen because we’ve allowed non-GAAP metrics to proliferate in the dialogue, the reporting, and the investor conversation.  Basing your investment decision on non-GAAP metrics mean there’s poor year-on-year comparable numbers and inconsistent standards among similar businesses.  Especially with these social and new media companies, they say they are profitable, and then the media and analysts say they are profitable, but then there’s a little note at the bottom that says, “on a non-GAAP basis.” 

You have real problems when you start letting companies say, “We define profit as this.  We define revenue as this.  We define gross margins as this.  We define how we count employees as this because we don’t count people that work less than 25 hours and that don’t eat in the cafeteria.”  When you start using non-GAAP, non-accepted accounting standards, metrics that are promoted by management and change quarter-to-quarter, then you hear things like, “We don’t count facilities in China that are 100% owned through a Chinese joint venture.”  When numbers are defined by management, then you have to ask, “Can I trust this management?”

Slepko:  So what is an investor to do?  What information should individual investors look at?  Is there anything that is consistently reliable? 

McKenna: In the Forbes article I did in November, [“Lying with Numbers: Is the SEC’s Ponzi Crusade Enabling Companies to Cook the Books Enron Style,”] I talk about how the SEC is not enforcing accounting fraud cases with the same vigor as Ponzi schemes, insider trading, and foreign bribery and corrupt practices because all that is the sexy stuff post-Madoff and all.  The SEC is not protecting you from accounting fraud because they say there’s not as much anymore, it takes too long t prosecute anyway, and it is just too hard to prove intent.  Plus, regulatory agencies are always going to be reactive.

At the end of the [Lying] piece, I go into detail on seven ways that the average investor can assess accounting risks to their own investments: (1) Scrutinize earnings revisions, (2) read the SEC’s mail, (3) watch for changes in auditors, (4) track the shorts and the chatter, (5) look for anomalies in the financials, (6) beware highfliers, and (7) watch for repeat offenders. 

By also seeing how companies compare to the economic reality that you know and how they perform relative to their competitors you can discern a lot.  Can one bank like JPMorgan (NYSE: JPM) be so much better than everyone else?  Obviously not.

Slepko:  What is currently going on with the Big Four auditing firms? 

Of all the firms right now, Deloitte is probably under the most scrutiny.  They lost the most clients during the financial crisis – Washington Mutual, Merrill Lynch, Bear Stearns, and now they are being sued over Hewlett-Packard and Autonomy.  In June, they are going to trial over Taylor Bean and Whitaker Mortgage (one of the huge frauds from the financial crisis).  Deloitte has also been the most scrutinized by the regulators – the SEC and the PCAOB.  They were the first to have issues related to China.  They were also the first Big Four firm to have a negative peer review – Ernst & Young formally criticized [Deloitte], and that’s unprecedented.

Second is a tie between PricewaterhouseCoopers and Ernst & Young.  EY is still fighting the shadow of Lehman, and is facing two suits related to Lehman. One with the New York Attorney General, and the other is some class action stuff.  Both are set to go to trial.  EY just settled Sino-Forest for over a hundred million dollars, and Sino-Forest is just a taste of similar transgressions EY’s got going on in Asia that no one is paying any attention to. 

PwC was once sitting triumphant while all the others were being taken down.  Currently, they are the preeminent financial services auditor and have Bank of America, JPMorgan, Goldman Sachs, AIG – still, no matter what, they still have AIG.  But now things are coming home to roost, and they have two lawsuits against them related to the Colonial Bank (NASDAQ: COBK) fraud – the FDIC has sued PwC, and there was already private litigation against PwC over Colonial as well.  Colonial is a very clear cut case of fraud, people have already gone to jail, and the regulators have access to all the work papers.  It is going to be tough for PwC.  PwC was also the auditor for MF Global (which is still pending), and PwC has been added as a defendant to one [MF Global] customer lawsuit, and there are likely more to come.  Things are going to get worse for PwC before they get better.

KPMG settled its Countrywide and New Century problems very early in the process.  They audit Wells Fargo, Citigroup, and Deutsche Bank.  Considering everything that is going on with the banks, from anti-money laundering, LIBOR, and foreign corrupt practices, observers are just waiting for the next whale to drag them in. 

Slepko:  Speaking of Wells Fargo, you write some of the most insightful things about Warren Buffett.  A lot of the Fools still worship at his altar, and maybe a decade ago that was a noble pursuit, but he doesn’t really do what he philosophizes about these days, though people still revel in his quirky form of marketing (as it makes for easy, feel good copy), yet in many ways Buffett is now the Anti-Buffett

McKenna:  Buffett and Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) is Deloitte again.  Deloitte does not get paid nearly as much as they should if you look at the number of companies in that conglomerate.  If the individual firms [of Berkshire] were on their own, what they would charge and the level of scrutiny they would receive would be very different.  Instead because they all roll up under Buffett you have this very minimal level of scrutiny that takes place in Omaha, and some of it that takes place in General Re, Burlington Northern, or some of the really big parts. 

Slepko:  Are you saying thirty people in Omaha aren’t enough to oversee one of the largest enterprises in the history of mankind?  (It is also amusing to note that Buffet’s Berkshire is itself a product of a reverse merger.) 

McKenna:  You could say that.  There is currently no one that will be able to hold that thing together after Buffett…[Within Berkshire,] you have big companies, like General Re, that are very sophisticated which were used to preparing the reports and numbers required when they were public.  Now, they have a little worksheet of ten numbers that they send to Omaha.

Slepko:  But it’s a charming anecdote that makes people feel good about how much Warren trusts his people and discerns their capabilities.  Clearly the alchemy he uses to secretly divine a successor – more than once (as the first attempt didn’t work out so well) – will pay similar dividends as his A shares.  Nor should the blatant dissembling he did about his famous secretary give anyone pause about how he plays fast and loose with perceptions. 

McKenna:  Stories about problems in the portfolio companies pop up all the time and are squashed like bugs, which is why I think when Buffett, dies and the company no longer has his presence, that cockroaches are going to really start coming out of the woodwork.

 

 

 


Nick Slepko (hukgon) has no position in any company mentioned here at the time of publication.  The Motley Fool owns shares of JPMorgan Chase & Co. Motley Fool newsletter services recommend Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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