Monday, August 20, 2007

Financial Auditors - What are They Good For?

Deloitte & Touche gives American Home Mortgage a clean bill of health three months before it declares bankruptcy. Auditing's new battle cry - 'Remember the Enron'?


Aug. 15 (Bloomberg) -- You think your job is tough? Think about the poor schlimazels from Deloitte & Touche LLP who blessed the books at American Home Mortgage Investment Corp., mere months before it went belly up.

The Deloitte accountants faced a crucial decision as they finished their audit work in March. Deloitte could resign and walk away. The firm could qualify its audit opinion by saying there was ``substantial doubt'' about American Home's ability to continue as a ``going concern'' through the end of the year -- as many short sellers already had concluded. Or it could give the company a clean opinion, expressing no doubt, which is what Deloitte did.

Five months later, on Aug. 6, American Home filed for Chapter 11 bankruptcy-court protection, still brandishing the firm's clean audit-opinion letter.

There's a reason why you don't see auditors pursuing second careers as tarot-card readers. They wouldn't be very good at it. Yet every time an accounting firm renders an opinion on a client's financial statements, the auditing standards say it must evaluate the company's ability to continue as a going concern, and warn the public if it concludes there's ``substantial'' doubt, a term the rules don't define.

The home-mortgage industry's growing casualty list is a reminder: They're not very good at that either.

You almost have to feel sorry for the Deloitte accountants who drew this thankless task. While in hindsight it looks like they made a bad call, they also were in a pickle.

Dreaded Language

Tucked inside American Home's credit-facility agreement was a clause that said the Melville, New York-based company would be in default with lenders if its auditor tagged it with the dreaded going-concern language.

For the accountants, if they thought for even a second about this, it must have felt like staring into a house of mirrors. Had they made what proved to be the right call, they probably would have inflicted a mortal wound on American Home. Then again, looking back, a self-fulfilling prophecy would have spared investors from the company's April 30 public offering of 4 million shares at $23.75 each, the prospectus for which incorporated Deloitte's audit opinion. American Home's shares closed yesterday at 22 cents.

The auditing standards stress that auditors are ``not responsible for predicting future conditions or events,'' and that a company's sudden failure without any going-concern warning ``does not, in itself, indicate inadequate performance by the auditor.''

Auditors' Judgments

Even so, financial statements depend heavily on auditors' judgments about a company's forecasts. Look at almost any balance sheet, and the asset and liability values hinge on the company's ability to remain in business. Those numbers would look far different if the company were preparing for liquidation, with holdings listed at fire-sale prices.

That's why going-concern evaluations by outside auditors are a necessity. Auditors may not be particularly skilled at making them. When they do bark, though, you can bet shareholders will skedaddle, because then it's clear the problems lack plausible deniability.

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