On Richard Murphy

I rag on Richard Murphy a great deal. I think he's extraordinarily wrong headed but that's not normally enough to get my dander up. The unfortunate fact is that he's also get a certain amount of power in our current political system. He writes reports for the TUC, he gives evidence to Commons committees and the like. His pamphlets are approvingly noted by such luminaries as Nick Cohen, Michael Meacher, Polly Toynbee....and such luminaries they are.

So as a special Christmas treat I thought I'd bring in a ringer, an American gentleman who blogs under the name Dennis the Peasant. Denis, like Richard, is a qualified accountant. Dennis, like Richard, has a couple of decades of running his own accounting firm under his belt. In fact, the firms are not of dissimilar size: neither of them has built a challenger to the Big Four, both have made a decent living in their profession. There're major differences I have to admit. Dennis labours under the American system of rules, Richard did so under our own. Dennis also seems to think that Richard doesn't know what he's talking about on the subject of audits. As he explains here.

"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?"

So we're left with an interesting question. Just why does someone so spectacularly wrong on his supposed subject of expertise have such power and influence in our political system?

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