Fox Guarding the Henhouse: Big 4 Auditors Chosen to Oversee Bailout Bill

PricewaterhouseCoopers LLP (PwC) and Ernst & Young (E&Y) have been chosen by the United States Treasury to help oversee the $700 billion bailout plan. CFO.com reports:

The government agency said the firms will provide Treasury with the accounting and internal controls services needed to administer the complex portfolio of troubled assets that the department will purchase. Those include whole loans and mortgage backed securities, under the Troubled Asset Relief Program (TARP).

PwC is supposedly going to focus on establishing good internal controls, while E&Y focuses on general accounting support and expert advice. PwC will initially be paid over $191,000 and E&Y over $492,000 for their services. (The actual fees will surely go far beyond that, but such numbers are necessary when bidding on these projects.)

What is not being said in regard to this oversight of the Bailout Bill is the potential liability that these auditing firms have related to bank and investment firm failures.

Auditing firms examine the financial statements of companies and are required to analyze valuations of assets, examine reserves and other estimates, and give opinions regarding a company’s financial status.

Does it come as any surprise that these auditors were responsible for the financial statements of organizations that have failed? PwC audited AIG and Freddie Mac. E&Y audited Lehman Brothers and UBS (which hasn’t failed yet, but is on shaky ground).

The closest PwC came to sounding a warning bell for AIG was this in the 10-k for the year ended December 31, 2007:

AIG’s management has concluded that a material weakness relating to the internal control over financial reporting and oversight relating to the fair value valuation of the AIGFP super senior credit default swap portfolio existed as of December 31, 2007. Until remediated, this weakness could adversely affect the accuracy or timing of future filings with the SEC and other regulatory authorities. A discussion of this material weakness and AIG’s remediation efforts can be found in Item 9A. Controls and Procedures — Management’s Report on Internal Control Over Financial Reporting.

Knowing what we know now about the financial condition of AIG, was a statement about controls over financial reporting enough of a warning? Financial statement audits are inherently weak in the assurance they provide about the financial statements and condition of a company. But where was the warning that AIG was close to implosion?

The 10-K also stated:

Notwithstanding the existence of this material weakness in internal control over financial reporting relating to the fair value valuation of the AIGFP super senior credit default swap portfolio, AIG believes that the consolidated financial statements in this Annual Report on Form 10-K fairly present, in all material respects, AIG’s consolidated financial condition as of December 31, 2007 and 2006, and consolidated results of its operations and cash flows for the years ended December 31, 2007, 2006 and 2005, in conformity with U.S. generally accepted accounting principles (GAAP).

So all is well? Right? The numbers are the numbers. No real warning that AIG was in serious financial trouble. (And I don’t think anyone would disagree that AIG had to be in trouble when these financial statements were issued. The problems didn’t spring up overnight.)

What about Lehman Brothers? Was E&Y carefully watching their numbers? Well if they were, they certainly weren’t telling anyone that the valuation of the assets was bad and the company was on the verge of collapse.

Francine McKenna of Re: The Auditors wrote recently:

All of the Big 4 firms have been very much involved, complicit, aided and abetted and/or been AWOL when it comes to the problems these firms faced and will continue to face.  The Big 4 audit firms neither helped them avoid these “crises”  nor helped warn others of the severity of the issues in enough time.  We find out how bad things really are only once a year, only when pushed, or as a result of a lawsuit. Or in these cases, we only found out when the firms were pushed to the edge of the abyss.

I don’t know what the answer is for oversight of the bailout bill. The Big 4 accounting firms are, for all intents and purposes, the only game in town. They have the depth necessary to audit very large companies, and by virtue of these large engagements, they only get bigger… a never-ending cycle.

The regional firms can’t possibly compete for some of these projects because they have neither the depth nor the know-how to do it. But without real competitors, the Big 4 essentially operate in a vacuum. There’s no real fear that their clients will find a better option. (In fact, one might suggest that each time a Big 4 firm turns a blind eye to financial issues, that only makes their potential clients want them more.)

The auditing system is broken. Our financial system is out of whack. But having Big 4 firms oversee the fallout, when they may bear some responsibility for not notifying us of the problems waiting to explode… that just doesn’t seem to make any sense.

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