The Scherzer Insider | Scherzer International

October 2010 / Issue 15

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Accounting firm client acceptance and retention decisions more risk-averse

It didn't end with Enron. The tough economy has exposed accounting firms to more defunct clients and shareholder lawsuits. With the globalization of capital markets and the expansion of securities litigation, the damages in a big case can be staggering. In confronting increased regulatory scrutiny and liability issues, accounting firms have become more risk-averse, and many are structuring their fees to match the perceived risk. Various accounting literature shows that the decision to accept and/or retain a client involves several criteria, including an assessment of the client's managerial integrity, financial condition, management controls and governance, positions on financial reporting, the audit firm's independence, potential profitability, staffing and expertise, and the integrity of risk information provided by the contact partner. Empirical analysis indicates that expected fraud risk reduces client acceptance, but expected error risk has no effect. Additionally, the auditors' business risk and the client's business risk are related; audit litigation subsequently reduces audit fees because the auditor's reputation suffers.

Predicting fraud continues to be a significant challenge for accounting firms. While several studies on fraud measures are underway, the most comprehensive material fraud analysis to date, commissioned by the Big 4 accounting firms' research advisory board, was conducted in 2005 by professors from the University of Washington Business School and the University of Michigan's Stephen Ross School of Business, along with Richard Sloan of Barclay's Global Investors (see the full text of this study here). Their research, compiled from reviews of more than 2,000 SEC auditing enforcement releases, revealed that growth companies suffering deteriorating operating performance were most likely to cook their books. Other common characteristics of firms that manipulated financial results included unusually high growth in cash sales but declines in cash profit margins and earnings growth, decreases in order backlog and employee headcount, and abnormally high increases in financing and related off-balance sheet activities such as operating leases. A consistent trend among the manipulating firms was that their performance was strong prior to the malfeasance, and that "manipulations appear to be motivated by management's desire to disguise a moderating financial performance."

Based on their findings, the professors devised a "fraud score" or F-Score, to be used by investors, auditors, and regulators as a preliminary assessment of "earnings quality." Of course, a background investigation prior to an engagement and for client retention also may identify red flags based on the subjects' history of reputational, financial, legal, regulatory and commercial issues (see Scherzer International's portfolio of investigation strategies for accounting firms.)

Tracking industry's hot topics:

Verdict rendered in two "in pari delicto" cases
Rulings have been issued in the two cases referenced in the September Scherzer Insider that involved questions about the legal liability of auditors in detecting corporate fraud. On October 21, 2010, the New York Court of Appeals ruled in Kirschner v. KPMG LLP, et al. and Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers LLP, et al. that accountants who allegedly should have detected malfeasance by executives of Refco in the Kirschner case, and by American International Group Inc. in the Teachers Retirement System case, cannot be sued under state law.

The court held that the principles under which the suits were dismissed -- in pari delicto and imputation -- are "embedded in New York law" and "remain sound." Imputation ascribes liability for malfeasance to a corporation and its direct agents under the principle that company officials are aware of and responsible for the actions of their agents, except for an "adverse interest" where corporate officers were found to have been acting solely in their own interests. In pari delicto allows for the dismissal of suits in which blame between wrongdoing defendants is deemed to be equal.

SEC's new rule requires issuers and underwriters of asset-backed securities to make due diligence findings available to the public
On October 13, 2010, the SEC issued a proposal to enhance disclosure to investors in the asset-backed securities (ABS) market that requires ABS issuers to perform a review of the assets underlying the securities, and publicly disclose information relating to the review. The proposal also requires ABS issuers or underwriters to make publicly available the findings and conclusions of any third-party due diligence report.

Decisions in enforcement of FTC's Red Flag Rules postponed
The Federal Trade Commission's enforcement of its Red Flags Rules has been postponed a number of times, and was most recently extended to December 31, 2010. The rules require creditors and financial institutions to address the risk of identity theft, by developing and implementing written identity theft prevention programs to help detect and respond to "red flags" that could indicate identity theft. The AICPA, the American Bar Association and the American Medical Association filed actions against the FTC to prevent it from enforcing the Red Flags Rules against their members.

Green Energy Scams

The emerging green-energy market has created a horde of fraudsters. So many, in fact, that late last year, FINRA warned about schemes that promise large gains from investments in companies that pitch alternative, renewable or waste-to-energy products. And in May of this year, the SEC followed with its own alert about potential scams that exploit the Gulf oil spill and related cleanup efforts.

The green-energy get-rich-quick schemes are showing up in blog posts, e-mail, infomercials, Internet message boards, text messages, and on Twitter. As with most investment scams, all promise unrealistic returns, such as a 200% stock gain by a solar panel company, a one-in-a-million deal to get a "51 times" return on current stock value from a China wind-power enterprise, and a 500% one week stock gain by a hydrogen-based energy outfit.

Requests for investigations of green energy companies are on the uptick for us too. In a recent case, the alleged cons approached one of our clients with a proposal that touted incredulous quick returns on their newly-brewed gasoline additive. But we found that both subjects had a trail of financial problems and lawsuits for fraud. For further information on preventing green energy scams and other frauds, visit the ScherzerBlog.