In the previous blog post on this subject I wrote about the pretty bad state of audits, even if performed by the "Big Four" companies.
But how would the situation be if an audit company is warned in detail about possible fraud or other financial irregularities, surely auditors will step up their game, zoom in on the situation at hand and give a proper report?
According to short seller Carson Block the answer is an astonishing "no".
In "Beware the false reassurance of corporate probes" (free registration might be required) published by the Financial Times he writes (some snippets):
When it comes to defending themselves against accusations of wrongdoing, management teams and their complacent boards follow a well-worn routine. Their immediate reaction is to issue a blanket denial and announce that an independent committee of directors will investigate the accusations. The committee duly appoints an independent law firm to oversee the investigation, and the consulting arm of a Big Four accountancy to pore over the books.
Too often, such investigations are worthless endeavours that lead to more pain for investors. Frequently, companies are exonerated by their boards but subsequently tumble into bankruptcy or announce earnings restatements or evidence of other serious problems.
Directors are not inclined to embarrass themselves by exposing serious problems that had long been under their noses. That would invite shareholder lawsuits, regulatory scrutiny and professional embarrassment.
Nor are they likely to relish the prospect of clashing with management when the chief executive is often the one who put them on the board in the first place. Board members may even be conspirators in the fraud. If they are based in China and have little connection to the US, they are unlikely to face prosecution.
Time and again, investigators report that they have found no evidence to support claims of wrongdoing. The question that investors need to ask themselves is: how hard did these investigators look for clues that might have revealed something was amiss?
The firms hired to support the probe are often given a deliberately narrow brief. For example, there might be tight restrictions on the investigators’ ability to investigate the sources of the company’s cash balances.
Fraudsters have repeatedly duped independent committees and their advisers by showing that they control large cash balances. Often, they do this by borrowing the funds. If directors make it impossible to detect such ruses by limiting investigators’ access to evidence, nobody knows; the entire process is shrouded by the cloak of attorney-client privilege.
Accounting firms are also rife with conflicts of interest. Their main line of work is auditing public companies. This makes them unwilling to heap embarrassment on management teams and boards. To do so would be bad for business.
That doesn't sound that promising. Block gives a concrete example:
In 2011, Sino-Forest Corporation, a China-based company listed on the Toronto Stock Exchange that Muddy Waters had accused of falsifying its revenue, spent approximately $50m on such an investigation, hiring PwC as a consultant. The result was a clean bill of health. In a press release announcing the completion of the investigation, the independent committee said the company was unequivocally “not the ‘near total fraud’ and ‘Ponzi scheme’ as alleged by Muddy Waters . . . Sino-Forest is a real company.”
Unfortunately, investors who bought Sino-Forest bonds following the committee report saw their prospects for recovery plunge when the company declared bankruptcy four months later.
The problem is not confined to emerging markets. In the US, numerous independent board investigations have issued clean bills of health, only to be proved wrong later on.
A report into wrongdoing at Enron, carried out by a law firm hired by the company, was later described as “a whitewash” by an Arthur Andersen investigator. When Global Crossing ordered an investigation into allegations levelled by a former employee, the report came back clean. Yet the company fell into bankruptcy and settled with the SEC over an accounting scandal.
The solution according to Block:
Boards that truly want transparency should stop hiring law firms to conduct these investigations in private and under legal privilege, and open their work to genuine scrutiny.
Hopefully 1MDB will follow this advice for increased transparency, it is long overdue.