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Auditing

Sucks to be Seidman

By now, the verdict in the BDO Seidman lawsuit has been covered by all the major industry blogs. All the heavyweights have registered their opinions in this great swirling mass known as the blogosphere. The mainstream media has tossed it around this way and that. There is near unanimity amongst all commenters: Sucks to be them.

I don’t disagree completely. For failing to detect a fraud perpetrated at E.S. Bankest LLC, Seidman is on the hook for $170 million in actual damages and a whopping $351.7 million in punitive damages. The combined amount of $521.7 million is the value of accounts receivable E.S. Bankest fraudulently reported in their financial statements, which were audited by BDO.

Naturally a lot of speculation has focused on whether the firm will be able to survive, assuming their appeal doesn’t reduce the damages. Big Four Blog does the math:

The WSJ says, “Testimony and evidence presented showed that BDO had profit distributable to partners of more than $170 million for its 2006 fiscal year, which ends in June, and a net worth of about $40.5 million. […] Among 250 partners works out to about $700,000 payout per partner. The $521 million damage is equal to three years of current year earnings. […] Can BDO Seidman effectively handle such a large amount of payouts, without losing its current structure? This is serious money for a medium sized firm.

It’s serious money, period. Jack says:

Even for the Big Four, $522 million is a lot of scratch. Recall that the Department of Justice fined KPMG $450 million in its tax shelter travails. That caused outsiders to wonder if it would interfere with KPMG’s equilibrium. This is not the way BDO Seidman would like to join the big leagues.

Just how much scratch a half billion really is for either a Big Four firm or a mid-tier one is not crystal clear. Francine asks the question:

When will the SEC and PCAOB start encouraging all the firms to be more transparent about their ability to continue to weather all of these high payouts? It seems we only hear there’s a problem with covering the liability when the firm is about to go under.

E.S. Bankest was part-owned by the plaintiff in the lawsuit, Banco Espírito Santo (Get it? E.S.!), and Bankest Capital. BES relied on “faulty audits showing that Bankest Capital’s income had nearly tripled from 1995 to 1996” when deciding to start the venture!

The entity was involved in factoring, which is when a third party buys accounts receivable from companies at a discount (to improve cash flow for the original company), collects the receivables and keeps the profit. Needless to say, the accounts receivable assets of a factoring company should be a main focus of a properly conducted risk-based audit.

Another interesting bit is how quickly the jury decided the firm had been negligent. One hour. Gross negligence. The evidence must’ve been pretty convincing.

The best evidence of the existence and accuracy of receivables is the confirmation. This is where the auditor takes a sample of receivables outstanding at year end and sends a letter to the customer asking them if they agree with the amount owed. If they agree, it is confirmed. If they disagree, they typically provide what they believe the balance was, and the two must be reconciled.

The strength of the confirmation should be obvious. Evidence coming from a third party is stronger than other procedures performed on AR like vouching to invoices and shipping documents, which are client-prepared.

The problem is that most confirmations are not returned. In my experience, I’ve gotten as few as 6 of 20 back, although it really depends on the organization and industry. I’ve heard that some companies or the management have a policy of not returning confirmations. Either way, when confirmations are not returned, the auditor has to fall back on alternative procedures, which are less persuasive.

Another typical procedure is the analysis of the aging of receivables. The longer a receivable has been outstanding, the less likely it will be collected. An auditor will identify larger receivables that have been outstanding for longer than 60 or 90 days, and discuss the situation(s) with management to assess whether the receivables are collectible.

Details regarding the failed audits have been unsurprisingly scarce, but it’s a good bet that the two areas above played a significant part.