Are CPA Firms Finally Being Held to Account for the Financial Meltdown?
Deloitte Touche Tohmatsu Ltd, the world's largest accounting and consulting firm, was accused on September 26 of failing to detect fraud during its audits of one of the biggest private mortgage firms to collapse during the U.S. housing crash. This was the latest lawsuit to hit one of the major accounting firms over their role in the credit crisis. Pricewaterhouse Coopers, KPMG and Ernst & Young are also facing accusations about their auditing standards by investors who collectively seek to recoup billions of dollars lost in the financial meltdown.
A trust overseeing the bankruptcy of Taylor, Bean & Whitaker Mortgage Corp, or TBW, and one of the company's subsidiaries filed complaints in a Miami Circuit Court claiming a combined $7.6 billion in losses. Deloitte spokesman Jonathan Gandal said the "claims are utterly without merit."
Lee Farkas, the former chairman of Taylor, Bean and Whitaker, was sentenced to 30 years in prison in April for masterminding what U.S. officials described as one of the biggest bank frauds ever. U.S. Justice Department officials said Farkas ran a $2.9 billion fraud scheme that led to TBW's downfall and the collapse of one of the largest U.S. regional banks, Colonial Bank. Farkas was accused of running a wide-ranging scheme to cover up large losses at Taylor, Bean, which was based in Ocala, Florida, by moving funds between accounts at Colonial Bank and also by selling mortgage loans that did not exist, were worthless or had already been sold.
The complaint filed by Neil F. Luria, a plan trustee of Taylor, Bean & Whitaker Trust, claims losses of approximately $6 billion. A second complaint by Ocala Funding, a wholly owned TBW subsidiary which served as a lending facility, claims losses of $1.6 billion.
"Deloitte missed this fraud because it simply accepted management's conflicting, incomplete and often last-minute explanations of highly-questionable transactions, even though those explanations made no sense and were flatly contradicted by the documents in Deloitte's possession," according to the complaint by Ocala Funding. Furthermore, “Ocala relied on Deloitte to detect material misstatements in the financial statements due to error or fraud.
According to Generally Accepted Auditing Standards (Statement on Auditing Standards No. 99), "The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” The key always has been the interpretation of “reasonable assurance” and auditor responsibilities to examine evidence. Generally, evidence provided by the client is less reliable than that gained by auditor communications with third parties and by applying accepted audit procedures. Deloitte apparently relied too much on management’s explanations and did not do its due diligence in collecting and analyzing data. Plaintiffs' lawyers argued that as gatekeepers, auditors have a duty to be vigilant at rooting out fraud.
One question that arises is whether Deloitte missed the red flags that fraud may be present. According to Jacob Zamansky, founder of Zamansky & Associates, a law firm specializing in securities fraud, “If [auditors] see something they need to report it. If they consciously ignore red flags, they could be held responsible as an aider or abettor to the fraud."
Auditors are expected to exercise professional skepticism in making professional judgments on the extent and scope of evidence to be gathered and in evaluating its usefulness in rendering an opinion on the fairness of presentations in the client’s financial statements.
From the auditor’s point of view they can take solace in a newly emerging legal defense called "in pari delicto," or equal fault principle, used when a company being audited was equally to blame for wrongdoing. It is very fast becoming a law of this nation, which is a tremendous protection for the Big Four." However, Steven Thomas, an attorney for the plaintiffs, said his case rests on solid legal ground. He said that a key bankruptcy decision holds that under Florida law, the in pari delicto defense does not apply in cases in which the auditor has a duty to detect fraud and in which there were innocent board members who could have been alerted about the fraud. "They (Deloitte) had a public duty to detect the fraud," Thomas said. "They didn't do their job, and that's what we're going to prove."
Deloitte has also been named in other big lawsuits stemming from the credit crisis, including one involving its audits of Bear Stearns, which collapsed after suffering enormous mortgage losses, and another involving Washington Mutual, the biggest bank to fail during the credit crisis. Critics have argued that the independent auditors should have predicted the dramatic and unprecedented decline in the housing market that shocked the entire industry.
Are auditors finally going to be held accountable for their role in the financial meltdown? Time will tell but there can be no doubt some must have missed the red flags and, more important, ignored the changing business model and risks inherent in dealing with financial instruments such as sub-prime mortgages and credit default swaps. Auditors are supposed to understand the environment in which their clients operate and use that knowledge and related risk assessment to determine proper audit procedures. It appears that Deloitte failed to do so and there may be other cases waiting in the wings.
Blog posted by Steven Mintz, aka Ethics Sage, on September 30, 2011