Thinking about audits By Fred Cederholm

Column for on/after January 6th, 2008

I’ve been thinking about audits. Actually I’ve been thinking about Julius Caesar, the accounting profession, financial services uniqueness, Sub-Prime/ Alternate-A derivative paper, and the Resolution Trust Corporation. The busy season for the accounting profession is at hand. I’m not just talking about the majority of the income tax filings for businesses (due on the Ides of March) or those tax filings for individuals (due on April 15th). January thru April is also the time frame when the lion’s share of the field work is completed for the annual audits of businesses and publicly traded corporations. Respective audit reports with those ever-so-critical independent accountant opinion letters are also issued.

You see the word audit comes from the third-person single conjugation of the Latin verb audio – meaning “to hear.” Historically, it was first used in “the somewhat accounting context” of Julius Caesar’s commentaries on his Gallic Wars – De Bello Gallico. Members of his troops “traversed the battlefields (after a conflict) and speared the wounded.” This was done to determine who was still alive and who was dead. They “audited” the casualties and reported the results back to their commanders. I have no doubt that in some (rare) cases those either being “examined” in financial audits by outside accountants, or those undergoing an IRS audit, may feel that the process hasn’t changed in 2000+ years.

The accounting profession in the 21^st Century is really a far cry from Julius Caesar’s troops. As a CPA/ CFE and forensic accountant who writes the weekly column TH*NK*NG, I am clearly biased to the profession despite the independence and professional skepticism I maintain both as an accountant and a writer. The attest function of the independent audit performed by the profession is critical to the business world, the banking industry at large, and the global equity/ financial markets. This has been true for a long time. In 2008, this will prove ever-more-so because of the looming crisis of derivatives.

The financial service industry is under the spotlight and has been so since August 2007 when the unfolding debacle of the Sub-Prime/Alternative-A derivative investments became the story on page one. TENs of BILLIONS of these have been written-off/ down worldwide with HUNDREDs of BILLIONS more to come. Such “investments” are literally popping up everywhere, but NOT necessarily where you might expect them to be! This current audit cycle will not only prove critical in identifying who is holding such dubious paper, but also what adjustments will be required to “fairly present” the financial statements (or statements of condition) of the entities under examination by the accounting profession.

While the public’s attention will focused on their banks and the timeliness of this year’s audit’s completion date as well as the nature of the independence accountants’ opinions – be they unqualified, qualified, adverse, or disclaimed; the real focus should be aimed at those audited financials and reports of investment bankers, mutual funds, hedge funds, money market funds, pension funds, municipalities, and insurance companies. While they may face concerns/issues regarding declines in local Real Estate values, and increased foreclosures; I foresee that the local/ regional community banks (who are locally owned and managed) and are not satellites of the national mega-money-center banks, will get thru their audits unscathed with flying colors. The proof behind my assertion will come in the next four months.

In terms of bigness, pervasiveness, and costliness, I fully expect this derivative investment crisis to surpass the Savings and Loan crisis of the late 1980’s and early 1990’s. There is still the potential for a similar cascading effect which would/ should/ could endanger the financial system of the entire planet if left unchecked. Back then, the doctrine of “too big to fail” ruled. Back then also, the “solution” came via the creation and mobilization of the Resolution Trust Corp. I worked there from February 1990 thru March 1993. This crisis is actually moving quicker. Will a re-activation of the RTC be required? Will there even be time? I’m Fred Cederholm and I’ve been thinking. You should be thinking, too.

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