PricewaterhouseCoopers a Defendant in Two Lawsuits Over Audits

In the last week Big Four auditing firm PricewaterhouseCoopers has been sued over its performance of audits of companies with massive frauds. First, PwC was named as a defendant in a suit filed by the Federal Deposit Insurance Corporation as the receiver for Colonial Bank.

Colonial Bank went under thanks to a fraud by Taylor Bean & Whittaker Mortgage Corp., its largest mortgage banking customer. Executives at Taylor Bean & Whitaker cooked up a scheme whereby they sold $400 million in worthless mortgages to Colonial Bank. The mortgages were worthless because they either did not exist, or had already been sold to other investors.

The lawsuit alleges that PwC failed to carry out its audit duties properly, and that if they audits were properly performed, PwC would have discovered the worthless assets on the balance sheet. It is further alleged that if the audits were properly performed, losses of $1 billion would have been avoided by Colonial.

The numbers in the complaint might boggle your mind. Colonial’s mortgage lending division accounted for $5.2 billion of Colonial’s assets, or 20% in 2009. $3.3 billion of the $5.2 billion was through Taylor Bean & Whitaker, which is  over 63%.

It is hard to understand how assets of this magnitude (both in terms of dollars, and in terms of the percentage of assets) could be non-existent, yet go undetected by auditors. The lawsuit points out that in 2007, pressure on the mortgage backed securities market should have alerted PwC auditors to increased risks. (Which should have led to greater scrutiny of the assets at audit time.)

And here’s an interesting allegation. The suit says that “PwC also relied on tests purportedly performed by others to confirm the effectiveness of internal controls, but it failed to recognize that no such tests had in fact been conducted.” Ouch.

How does that happen? The suit says that Crowe Horwath was going to do testing of certain “lower risk” areas of internal control, and that PwC was going to independently verify the quality of the testing. Allegedly, controls related to $1.5 billion of certain assets were never tested by either PwC or Crowe Horwath.

Then PwC allegedly went on to “audit” the $1.5 billion of assets only by having Taylor Bean & Whitaker confirm the balance. Due to the high balance and the risk surrounding mortgage products, the lawsuit alleges that the auditors should have done much more:

“Professional standards required the application of more robust audit procedures for the AOT facility, such as confirming with end investors the validity of takeout commitments or subsequent-events testing to trace funds coming from end investors after year-end and comparing such cash receipts to the underlying settlement documents and cash receipts records.”

Further, the lawsuit states that PwC planned to verify the collateral, but then abandoned that audit procedure.

And the big kahuna: “PwC’s execution of planned audit procedures was carried out so carelessly that the audit evidence did not provide a valid basis for its conclusions and its unqualified audit opinion.”

Specifically, the lawsuit alleges that PwC never saw any detail behind the $1.5 billion balance, but still concluded that controls over the reconciliation of this account were effective. It further alleges that if detail had been examined, the fraud would have been discovered since 40% of the transactions in this balance were bogus.

And it is alleged that PwC planned to test mortgages by comparing balances to supporting documentation. This procedure was abandoned in favor of looking at a list (compiled by a Colonial executive!) of mortgages that were supposedly repaid following the year end. But none of those repayments were verified either.

There is much more detail in the complaint about the red flags that auditors should have seen, substantial risk factors they should have identified, and discrepancies and lack of documentation which should have had a huge impact on the audit work.  Over and over, it is alleged that PwC auditors didn’t follow-up on problems or verify assertions by Colonial.

Next up, PricewaterhouseCoopers was sued relative to its audits of MF Global. The auditors are being accused of opining that the company’s controls over the safeguarding of customer assets were effective, even when they weren’t. It is alleged that PwC received internal audit reports from MF Global which indicated that there were internal control weaknesses. Despite this information, it is alleged that PwC didn’t properly test the controls over customer funds.

Last week Francine McKenna wondered when MF Global’s auditors would be held to account. This may be just the beginning.

And while audits generally do not do a good job of detecting fraud (since they are not designed to do so), it appears that in these cases, evidence of fraud may have been sitting right in front of the auditors’ faces. It’s one thing to miss a fraud that is cleverly designed and carried out by executives. It is another thing to miss huge red flags and risk factors, in conjunction with data that doesn’t make sense.

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