Time for Some Adult Supervision of Richard Murphy...

Our favorite progressive Euroweenie accountant, the ever-dim Richard Murphy (known forever more as 'Our Dickie' in these here parts), was a very busy boy last week, and judging from the results it appears some adult supervision is in order...

First, he whipped up a laughable "explanation" of the laughable Green New Deal proposal he co-authored with his fellow Euroweenies at the New Economic Institute. Had either the manifesto itself or Our Dickie's explanation thereof been a bit more detailed, we'd have been sorely tempted to distribute bingo cards and commence with a game or two of Buzzword Bingo.

Alas, it was not to be. Anyway...

Not satisfied with the degree of lasting damage to his reputation such silliness has no doubt brought about, Our Dickie then moved on to ruminate on the immediate need for a financial transactions tax because, as we all know, what is needed in a period of massive deleveraging and illiquidity is a new tax guaranteed to decrease the velocity of money.

And, still not satisfied with the degree of lasting damage that bit o' intellectual dreck has done to his reputation, Our Dickie then went on hit the trifecta with a post entitled Time for Adult Supervision of Auditors, which becomes - at least for ol' Dennis - an instant classic.

Here goes:

The F[inancial] T[imes] has reported:

Top accounting firms were hoodwinked by Bernard Madoff's alleged $50bn fraud as several leading banks and some of the world's biggest hedge fund investors, according to lists of service providers to Madoff-linked funds.

PwC, KPMG and Ernst & Young, three of the "big four" accountants, and an arm of BDO International, the fifth largest were all auditors of the feeder funds which channeled money into accounts at Mr. Madoff's New York Brokerage.

Mr. Madoff, who has been charged with fraud and electronically tagged, told investigators his business was "one big lie", according to prosecutors. The head of the US brokerage industry's compensation scheme said records at Bernard L Madoff Investment Securities were "certainly falsified".

Before we launch into Our Dickie's screed about how the Affaire d'Madoff conclusively proves the unreliability of auditors and auditing, it's worth our time to review several facts... largely because Our Dickie will mangle each of them at some point:

Fact the First: The fraud (as alleged) was committed by Bernard L Madoff Investment Securities, not the feeder funds audited by PriceWaterhouseCoopers, KPMG, Ernest & Young or BDO International.

Fact the Second: Bernard L Madoff Investment Securities was "audited" by the firm of Freihling & Horowitz, a three person accounting firm with exactly one active CPA, David Friehling, and not by either PwC, KPMG, E&Y or BDO.

Fact the Third: Financial audits aren't designed to detect fraud, in no small part because the express purpose of an audit is to allow the auditor to express an informed opinion as to whether the company's financial statements conform with generally accepted accounting principles (GAAP), are free of material misstatement, and present an accurate representation ("true and fair view") of financial position and operating results.

Got that? Good. Now here's Our Dickie:

Do not expect them [PwC, KPMG, E&Y and BDO] to have any liability though. Remember, because auditing firms changed the rules of auditing there is no requirement that they report that the accounts of an entity now show a true and fair view. They have only to report that the financial statements give a true and fair view in accordance with the applicable financial reporting framework. This is something very different.

This is genuinely bizarre, coming as it does from a trained accountant, which is what Our Dickie is.

First of all, the auditors noted did not audit the books of account of Bernard L Madoff Investment Securities. Madoff contracted with Friehling and Horowitz for the audit of Bernard L Madoff Investment Securities. This fact seems to have eluded Our Dickie. Either that, or his expectation was that the four accounting firms should have formed a strike force of elite auditors, created a diversion, stormed Madoff's offices and then audited the company by force. I'm not really up on how audits are conducted in the U.K., but what I can say is that paramilitary accounting strike forces performing forced audits on non-client companies has not yet found much acceptance within the accounting profession, regulators or the business community here in the U.S..

Secondly, Our Dickie seems to be of the opinion that companies are no longer required to present their accounts in a "true and fair view" because sinister audit firms have changed the rules so that companies need only show their accounts in a "true and fair view" that is "in accordance with the applicable financial reporting framework".

Think about that for a moment.

If not "in accordance with applicable financial reporting framework", then in accordance with what? In the U.S. we have what are called generally accepted accounting principles (known as GAAP), and their usefulness is that they define and codify what Our Dickie calls "true and fair". Evidently Our Very Egalitarian Dickie prefers the idea that every soul on the planet have the ability to define what constitutes a "true and fair view" of a company's accounts.

Personally, we don't see any problem with that.

Note the Third is this: Audit firms don't set either accounting or auditing rules in the U.S.. Generally accepted auditing standards (GAAS) are set by the American Institute of Certified Public Accountants (AICPA) and are supplemented by requirements set forth by governmental agencies (such as the Securities and Exchange Commission) and legislative bodies (such as Congress).

Undeterred by his own ignorance, Our Dickie continues:

If, as was the case when I was trained as an auditor, you had to ensure that the accounts gave a true and fair view then you had to look to beyond [sic?] the evidence that the client is presented to you and assess whether it was credible. Now, however, the relevant and applicable financial reporting framework is fair value, mark to market, reporting. In that circumstance all the auditor has to prove is that there is a market for the security that is traded, and no doubt there was the those [sic?] that Madoff was supplying. There was no obligation on the alter [sic?] to look behind act [sic?] to check whether the security has real worth.

This will, no doubt, be a matter of some considerable relief to the partners of the firms in question.

Of course, it's [sic] fundamentally undermines the whole meaning of audit. And it undermines the whole credibility of the audit profession.

It's at this point that we started suspecting Our Dickie had gotten into the brandy.

He contends that back in the Good Old Days, auditors were manly men: They rolled up their sleeves, gave their clients a mean, don't-screw-with-me glare with their steely gray eyes, and growled "Prove it, Pardner." All of which suggests Our Dickie, besides getting into the brandy, might have watched one too many Clint Eastwood westerns while the bottle was in hand.

The reality of the matter is this: The appropriate auditing procedures used when testing marketable securities haven't changed simply because they are now presented at market value on the balance sheet (as opposed to lower of cost or market). The amount of work the auditor has to do on a marketable security is determined by the state of the market for that security. If the security is widely traded, less audit testing is needed to establish a reasonable valuation than when the security is thinly traded. It is that simple.

There are four other factors to note here.

First, given that Madoff had billions in the marketplace, arriving at a reasonable valuation probably wasn't an issue. The Madoff securities had a market and valuation was readily determinable.

Second, and we repeat ourselves here, none of the four auditing firms were in a position to demand that Bernard L Madoff Investment Securities allow them to "look behind" anything. In the real world (as opposed to Our Dickie's world) there's this thing called privity of contract, and what it does is keep total strangers - who may or may not have brandy on their breath - from walking into your business and demanding to go through your books of account.

Third, what exactly does Our Dickie mean when he says auditors used to "look behind" things to "check whether the security has real worth"? The last time I checked, the market determined the real worth of a marketable security. Just what would Our Dickie be looking at? Madoff's hedge positions? Madoff was running a criminal enterprise, complete with elaborately forged documentation to cover the Ponzi Scheme he was running. Had Our Dickie "looked behind" to Madoff's documentation, he would have been duped. Even if there had been no fraud, in the interests of getting it really, really right, would Our Dickie have then decided it was necessary to "look behind" Madoff's documentation? And if so, to what? At what point has one "looked" enough to satisfy Our Dickie?

Fourth, it should be noted here (and again, we realize we repeat ourselves) that Our Dickie clearly hasn't the faintest idea that (in the United States, at least) financial audits are not designed to detect fraud. They are designed to allow the auditor to express an opinion on whether a company's financial statements conform to GAAP, are free of material misstatement and accurately present the company's financial condition and operating results for the period of time in question.

The bottom line is this, if Our Dickie thinks Affaire d'Madoff has undermined the meaning of an audit, it's only because he doesn't understand either the meaning or the actual purpose of an audit in the first place. And Our Dickie being Our Dickie, then goes on to prove our point for us:

That is an issue [mark to market] that does, however, have to be addressed. Auditing has been degraded to the point where it is utterly meaningless. Financial reporting standards allow the preparation of accounts that are meaningless. The profession's credibility is in tatters and real people are losing. Yes, I know this was a fraud [my emphasis], but some apparently saw it coming. As the Guardian has reported:

A Boston fraud investigator, Harry Markopolos, has revealed he waged an unsuccessful eight-year campaign to alert the SEC [my emphasis], sending documents and peppering officials with phone calls arguing that the financier's purported 10% to 12% annual returns were illusory.

Markopolos, who used to work for a rival fund management firm, became suspicious in 2000 when he analysed Madoff's investment method to see whether he could emulate it. He calculated that there were insufficient options in existence to support the amount of hedging Madoff claimed he was doing.

I believe him. I know that feeling of crying out about a system that is obviously corrupt and no one wants to listen.

Wow. It seems Our Dickie's in some serious pain here. Makes us want to cry out. And we would... if only anyone would listen.

But since they won't, let's skip the drama and look at the facts.

Fact the First: Harry Markopolos went to the Securities and Exchange Commission, not the four dastardly audit firms of the feeder funds. Now why would he do that? Well, my guess is that Markopolos - unlike Our Dickie - actually understood that as regulator of marketable securities and the firms that sell them, the SEC was the appropriate place to make his suspicions known.

Fact the Second: Harry Markopolos didn't take his suspicions to either the feeder firms or their auditors after being brushed off by the SEC. Why not? Well, my guess is that Markopolos - unlike Our Dickie - actually understood that as regulator of marketable securities and the firms that sell them, the SEC was the appropriate place to make his suspicions known. It also seems to suggest Markopolos understood the concept of privity of contract and the legal limitations it would impose of third parties (such as the audit firms).

Fact the Third: Our Dickie will no doubt opine that had PwC, KPMG, E&Y and BDO been doing their jobs, they would have done the same sort of analysis that Harry Markopolos did. It sounds wonderful, but the reality of the matter is simple: Harry Markopolos suspected fraud. That's why he performed his analysis in the first place. Lacking any reason for suspicion (let alone evidence of fraud), why would the audit firms spontaneously decide such analysis was needed? And sans evidence, why the feeder funds pay their auditors go above and beyond generally accepted auditing standards to perform such an analysis?

Fact the Fourth: Where Our Dickie a bit more familiar with finance, he'd know that if there was any sort of burden to "prove" what was "behind" the Madoff securities, it rested with the feeder funds, not their auditors. Those of us in the real world call it due diligence on the part of management. If any party was obligated to test Madoff's investment strategies for validity, it was the management of the feeder funds, not their auditors.

And so it goes. Having misunderstood the facts of the Madoff case, the function of an audit, the responsibilities of the SEC, as well as various and sundry legal and accounting concepts, Our Dickie gives us The Big Wrap-Up:

There's no doubt that auditors are amongst those who will now need to be subject to 'adult supervision' of the sort Barack Obama described yesterday. It's well overdue.

The days of the 'chaps looking over the shoulder of the chaps' has to end.

What Our Dickie fails to note is this: Based on what we know to date, if there is any entity in need of 'adult supervisor' in the Affaire d'Madoff, it is the Securities and Exchange Commission, not any of the audit firms mentioned. The facts point not to audit failure, but to regulatory failure.

Why this escapes Our Dickie is obvious; it doesn't mesh with either his professional world view or his preconceived notions about the largest of the international accounting firms. In Our Dickie's world, all auditors, and all audit firms are part and parcel of an evil capitalist financial system. So it follows that all difficulties encountered by that system must, in some way, demonstrate the evil nature of the auditor. To Our Dickie, the auditor is a sort of flawed superman, incapable of surmounting any and all economic problems encountered not because of the inherent limitations of the audit process, but because of the inherent (capitalist-inspired) greed of the auditor.

Fortunately for us, and just as unfortunately for Our Dickie, the sort of men Barack Obama has selected to provide 'adult supervision' include people of the caliber of Tim Geithner and Larry Summers who, not surprisingly, correctly understand the role of the SEC, audit firms and financial audits within the world of securities markets.

When one notes Richard Murphy's inability to master some of the most basic concepts of his profession, and his inattention to the facts of the Madoff case that are known to date, it seems clear that irrespective of whatever supervision is needed elsewhere, Our Dickie could use as much adult supervision as the profession of accountancy can possibly provide. Will the U.K.'s chartered accountants rise to the occasion? If not, we suppose we'll have verified that the days of 'chaps looking the shoulder of the chaps' hasn't ended quite yet.

Right?

 

Comments

[Eric Blair]

Thanks for writing that up.

My aquaintances and I are still a little fuzzy on how Madoff got away with what he got away with for so long.

Although it doesn't answer the question why. It's not like Madoff really needed the money, was it?

[markg8]

Please define what "free of material misstatement", and "present an accurate representation ("true and fair view") of financial position and operating results" means if it doesn't mean "yeah we went over the books and crosschecked his trades against what went on in the markets on those dates and he really is legitimately making that kind of money for his clients using brilliant trading methods. If Murphy is right about Markopolos Madoff's methods were no secret, he tried the same system and discovered "there were insufficient options in existence to support the amount of hedging Madoff claimed he was doing." Finding that out sounds to me like the definition of due diligence.

Seems to me if I have substantial amount of money to invest with a dealer I ought to have the right to have professionals audit his past trades to see if he indeed did what he said he did. And where would I expect to find those professional auditors? At the biggest US accounting firms? I guess not.

The SEC? Bush's SEC, the regulatory agency Phil Gramm emasculated before he left the senate and cashed in with UBS? Sadly not them either.

A real red flag might have been that Madoff's own sons who worked for him, who eventually turned him in, didn't let daddy manage their money. These geniuses gave their business to Lehman Bros.

[Dennis The Peasant]

Mark-

Why did I just know you couldn't go 100 words without blaming Bush for this? Doesn't blaming Bush for everything get a bit dull after a while?

You are right about one thing, though: An analysis of Madoff's trading system, such as the one done by Markopolos, might have alerted the managements of the feeder funds that there was something amiss. But the point is that Murphy is claiming it was the responsibility of the audit firms to perform due diligence, rather than the managements of the feeder firms, which is clearly incorrect.

And once again I'll point this out: Madoff's auditor was the only audit firm in the position to discover this fraud via auditing. That's because Madoff's auditor was the only audit firm with a legal right to examine Madoff's books of account. What seems to be emerging about Friehling & Horowitz is that (a) they weren't qualified to audit, and (b) David Friehling lied to the AICPA about his firm's professional activities. My guess is what we will find is that David Friehling was an active participant in the fraud.

[Dennis The Peasant]

Seems to me if I have substantial amount of money to invest with a dealer I ought to have the right to have professionals audit his past trades to see if he indeed did what he said he did. And where would I expect to find those professional auditors? At the biggest US accounting firms? I guess not.

Well, as a matter of fact, as an investor you don't have the right to have professionals examine the books of a dealer or fund manager. The legal concept behind that is privity of contract, and it was in place prior to the Bush Years, so you can't blame him for that. Sorry to ruin your day.

Legitimate funds and fund managers are required to make statistics regarding fund and manager performance public, and those figures are audited by the auditors hired by the funds. Madoff forged the statistics and made them public. Had Friehling & Horowitz actually audited Madoff's books of account, the fraud would have most likely been discovered rather quickly. What is clear to me, as a professional, is the David Friehling never bothered to actually do the audit he was contracted to do... although whether it was incompetence or criminality has yet to be established.

[markg8]

Doesn't blaming Bush for everything get a bit dull after a while?

LOL, hell you guys are still blaming Jimmy Carter and Bill Clinton for half the troubles in the world. George Bush isn't even out of office yet, there are eggs of his that haven't even hatched let one grown into chickens that come home to roost. So can we all please just forget about him? Um no. We're not going to sweep any of the last 40 or so years under the rug. Nixon was a crook. Reagan sought to dismantle as much of the US government as he could. George Bush just about completed the job with the kicker of letting various friends bilk the US government for billions in his privatization schemes.

But regarding this specific debacle, Affaire d'Madoff, the blame will probably fall on Chris Cox at SEC. He deserves it but in the end he's just a pawn. None of the ideologues who thought it was a good idea to let Wall St. police itself would have promoted him for the job in the first place if they thought he'd make the SEC a functioning regulatory agency. And he didn't let them down.

[ZT]

markg8: Markopolos went to the SEC in 1999. It's amazing how Bush was able to keep the SEC from being a functioning regulatory agency even before he was elected.

[Peter VE]

This sounds like a rerun of the Frank Gruttadauria scam, except it went on longer and the sums involved had a couple more zeros at the end. Well to do investors boasting of the returns their broker was making. No one looking too close at the numbers. My favorite part was that Lehman Brothers sent all the client statements to a single PO box, from which Gruttadauria would retrieve them, discard them, and write his own to send to the clients. Due diligence on their part.

[Dennis The Peasant]

ZT-

Remember, George Bush is everywhere...

Q: What board game does Mark play every day?

A: The Six Degrees of George W. Bush.

[markg8]

Sadly according to my Aunt L'nore I am distantly related to the Bushes. That'll happen when some of your forebears came over on the Mayflower. I can not be held accountable for the peccadillos of my ancestors.

And Dennis it's not just Bush, it's the silly conservative notion that became the movement's raison d'être best expressed by Grover Norquist: "I'm not in favor of abolishing the government. I just want to shrink it down to the size where we can drown it in the bathtub."

There's no way in the world we can run a 21st century post industrial nation with just 18th century laws, rules and regulations. It should surprise no one when the SEC's budget was slashed, it's regulatory power hamstrung and idealogues who don't believe in enforcement were put in charge it didn't do it's job.

There's a lot of people who should have known better who went along with the gutting of laws, firewalls, and regulatory agencies on Wall St, Rubin for one, but dismantling as much of the federal government's regulatory function as possible has been one of the single biggest objectives of the conservative movement for decades. Let's not pretend any of this had to happen and let's not fool ourselves about why it did. We tried that great conservative experiment with government and it's been an utter failure. It would have made no difference if John McCain had won the WH in 2000 instead of George Bush.

[just passin by]

"There's no way in the world we can run a 21st century post industrial nation with just 18th century laws, rules and regulations"

Sure...let's get rid of the outdated concept that free speech allows the rest of us to criticize our moral and intellectual superiors like Obama.

Let's ditch the idea that the individual should set his own economic course and reap the rewards of hard work. I think the government SHOULD have an agency devoted to wiping my bottom for me.

It is sad that the 18th century concept, that the Constitution should be able to limit what government can do, is still adhered to in this country, isn't it?

But I am full of Hopey Change and Changey Hope that our new administration will fix all these mean old 18th century laws. That way we won't have to move to Europe with it's surging, morally correct economy, and it's racially harmonic car burning riots. We can get all those things here. YEEEAAAAAAHHHHH!!!!