"It’s déjà vu all over again." - Yogi Berra
Well, it’s been a week since the U.S. Securities and Exchange Commission (SEC) announced that it was charging a KPMG partner and senior manager with failing to properly audit a bank’s allowance for loan losses. I share Jon Weil’s frustration with the SEC’s failure to pursue the large accounting firms for their shoddy audit work during the recent global financial crisis. Why you ask? It just so happens that back in the day, I actually audited financial institutions for KPMG’s predecessor firm, Peat Marwick, during the S&L crisis. I remember well how regulators and markets “punished” big accounting firms who failed to exercise professional skepticism in their reviews of land development and construction loans, equity participations, and yes, even reverse repurchase agreements. Despite all the angst that the S&L litigation created among auditors, it actually did make auditors think more about what they were doing. In short, litigation losses are one way to make sure that auditors have “skin in the game.” But I digress…
So what’s my beef this time? Well, I am not going to pile on after Jon Weil’s and Tom Selling’s pointed comments concerning the lack of auditor enforcement actions. After all you know how the grumpies feel about enforcement. See PCAOB is Too Soft on Auditors, Accountants Behaving Badly, and The Auditor’s Expectation Gap for a trip down memory lane.
Instead, I am just going to reminisce (and vent) about the “golden days of auditing” (when I practiced) to highlight what I consider to be the folly of the Financial Accounting Standard Board’s (FASB) recent exposure draft (ED) on Financial Instruments – Credit Losses. In fact, the very existence of this FASB proposal may help explain why KPMG couldn’t audit the loss allowance of TierOne Bank.
Immediately after reading page 2 of the exposure draft, I began to feel uneasy. The FASB tells us that the proposed amendments would require:
- An entity to impair its existing financial assets on the basis of the current estimate of contractual cash flows not expected to be collected on financial assets held at the reporting date.
- That the impairment would be reflected as an allowance for expected credit losses.
- The estimate of expected credit losses would be based on relevant information about past events, historical loss experiences, current conditions, etc.
So what’s so unreasonable about these proposals…absolutely nothing. This is what we were supposed to do 30 years ago! From intermediate accounting, through bank level I and II firm training, we learned that the allowance for credit losses (whether they be for accounts receivable or loans) should be based on exactly such criteria. So when did generally accepted accounting principles (GAAP) abandon this “old” approach, and what has been used since?
Well, page 3 of the FASB ED provides some clues. It indicates that current GAAP delays the recording of credit losses until they are “probable.” So, apparently corporate accountants and their auditors have adopted a strict interpretation of ASC 450 which requires that a loss contingency (a loss reserve) be accrued only if asset impairment is probable and estimable. Also troubling is that entities currently can limit the information they use to measure an incurred loss to “past events and current conditions,” ignoring a wealth of quantitative and qualitative factors specific to borrowers.
Apparently, today’s accountants believe that FASB’s pronouncements are the only thing that constitutes GAAP, choosing to ignore such tried and tested estimation techniques such as aging of accounts and percentage-of-sales methods. By the way, both tools are acceptable under GAAP, but neither apparently meets ASC 450’s level of “sophistication.” Back in the day, we acquired all the relevant information that we could to address the uncertainties associated with a loan receivable’s ultimate collectability.
With today’s high standard for recording a loan loss, it’s no wonder that loss allowances are being under accrued, particularly given bank management’s incentives to prop up capital levels at all costs. So, at some point, today’s accountants opted for a strict adherence to ASC 450’s criteria when creating and auditing loss reserves, ignoring other relevant GAAP, and abandoning common sense and skepticism, as well. And the result? A new FASB ED on credit losses (with implementation guidance) that simply confirms what we old auditors have known for decades. Wow, how did accounting for credit losses get so far off track?
A “war story” from my loan review days will hopefully illustrate why I am upset. One of my all time favorite loans was a $500,000 commercial real estate credit on a car wash in a small town. The loan was over 9 months delinquent, the bank had no recent communication with the borrower, but there was a stale property appraisal from when the loan was originally approved. The prior year bank examiner report had classified the loan as substandard, and the bank’s credit analysis department had currently evaluated the loan as doubtful.
Our concern back in those days was whether the reported loan amount (i.e., the contractual cash flows) was impaired. Given the information provided to us, it became apparent that we had to determine and evaluate the source of repayment. I gathered up my audit team at lunch and suggested we swing by the car wash for fun to check out the loan’s collateral. Yes, we actually conducted a visual inspection of the collateral…what a novel idea! And what did we find? A roofless, abandoned aluminum shell, totally stripped of machinery, laying dormant in a weed infested lot. Yes, this was an easy one…a complete loss with a 100 percent required reserve, not even any value for the land due to environmental hazard issues. Note the similarities of this situation with that summarized in the SEC’s action against the KPMG auditors at TierOne Bank: reliance on stale appraisals and management’s uncorroborated representations.
By the way, further investigation back at the bank revealed that the aging schedule for the car wash loan had been falsified, and that relevant borrower correspondence had been removed from the loan file. Yes, my little lunchtime adventure had uncovered a bit of a fraud! You can be assured that such little trips became standard for troubled loans in my future audit engagements. So what’s the moral of this story? You can’t audit from your cubicle…you can’t rely solely on management assertions…you can’t cut corners! And again, this grumpy old former Peat Marwick trained bank auditor was using FASB’s newly (and recently) proposed rules, over 30 years ago. I must confess that ASC 450 (SFAS No. 5, Accounting for Contingencies) never even entered my mind during the loan review process, nor did such terms as “probable” and “estimable.”
So what really went wrong with the KPMG audit at TierOne Bank? If we discount auditor fraud and gross negligence entirely, potential causes fall into one of two categories neither of which is likely to lead to a “conviction.” First, there is education…the “I didn’t know what I was doing” defense. This might work for a newly hired auditor on up to senior, but not for a manager or partner. They clearly had the education, specialized industry training, and years of experience necessary to plan, organize, and conduct substantive and control focused audit testing. Unless, of course, both the partner and manager argue that they were unsure how to apply current GAAP as it relates to credit losses.
The other, and more likely, explanation for blowing the audit of the loss allowance is poor process execution. Something undoubtedly happened during the engagement that resulted in a process breakdown. The usual suspects are time and client fee pressures which result in judgment, organization, planning, review, staffing and/or supervision failures during the audit process. I’d bet on this given all of the audit model failures recently witnessed, and the PCAOB’s continuing exception reports.
Oh, and don’t look to new accounting and auditing standards to fix the problem with loan loss reserves. I agree completely with Tom Selling’s recent statement that:
"The facts are that holding management ultimately accountable for the accuracy of financial statements doesn't work anymore (if it ever did). Different auditing standards won't make the audit more reliable as a deterrent to financial manipulation, so long as management has the license to do the estimating – and to hire and fire the auditors."
So what do I hope you take away from my ramblings about yesteryear? First, there’s nothing really new about FASB’s Financial Instrument – Credit Losses exposure draft. I support it! However, we all should be very concerned that FASB thinks that considering contractual cash flows and all relevant information in credit loss estimation and recognition is something new! Apparently, the FASB has no historical perspective or institutional memory…very sad, indeed. After all, even Jerry Maguire got it back in 1996 when he screamed "show me the money!" It was true then, it’s true today, and will be for the foreseeable future when it comes to valuing assets. And the FASB staff really ought to check out the wealth of published regulatory guidance if they want to craft a credible credit loss standard (e.g., OTS Asset Quality, Section 260 for one).
Lastly, in this grumpy old accountant’s opinion, quality accounting and auditing is less about financial measurement models and internal controls, which are valueless without the individual accountant’s commitment to common sense, sound judgment, and professionalism. Think of me the next time you take a drive at lunch to check out that non-performing strip center commercial real estate loan…yes, the one with the nail salon anchor tenant…
This essay reflects the opinion solely of the author.