Sunday, April 1, 2012

The Auditors Are Part Of The Problem

There is an interesting article in barrons on forensic accountant Howard Schilit — author of the excellent book: Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. Schilit says:
Here is how the auditors look at the world: They think of themselves and their legal liability issues first; if it's in the rule book and disclosed, you are covered. Second, they think of their clients. The client asked them to do something, and they want to please the client. A very distant third is they may occasionally ask: How does this look from the perspective of the investor? Investors would be astounded if they realized that this is how the party that is supposed to protect them views the world.
This reminds me of what Charlie Munger said at the University of Michigan.
Of course, the adults who could have fixed it, like the accountants who had ridiculous standards, without which a lot of the bad behavior wouldn't have worked. The accountants utterly failed us. By the way, there's practically no sign of any intelligent reversal of that failure of that profession. I have yet to meet many accountants who are the least bit ashamed for their contribution to our recent troubles, but it was immense. Imagine when Enron comes down to the SEC, and says, "We want to write a little contract with A and a little contract with B. And take all the profits we're going to make from these complicated contracts over the next 20 years into earnings immediately, and put an asset on our balance sheet of $28 million from signing two pieces of paper." And the SEC, led by wonderful accountants who have studied in great places, "Why, of course you should have that kind of accounting." What the hell were they thinking? [laughs] How could anybody have any respectable understanding of human nature without realizing that the kind of people who are going to be tempted by that accounting were not going to be able to resist the temptations? It was disgusting.
When asked — "What happened to the accounting profession and what can be done to try and fix it?" — Munger responded:
Well, partly they sold out. Partly they legitimately fear the liabilities that would come if they had to make more difficult judgments. It's a very, very difficult problem. It could be done by changing laws and rules very easily. And it would cause an enormous upheaval in America, which would be hugely to the plus. 99 percent of the troubles that threaten our civilization come from too‑optimistic accounting, and yet these damn accountants with their desire for mathematical purity want to devote exactly as much attention to accounting that's too pessimistic as they devote to accounting that's too optimistic. Which is crazy! Way more than 99 percent of the problem is from being too optimistic. Therefore, we should have a system where the accounting is way more conservative.