Sunday, November 12, 2006

Audit Committees and External Auditors: A Perfect Storm for Disaster

We are supposed to believe that public company external auditors working with audit committees pose an effective deterrent against corporate malfeasance.

However, from my own experience at Crazy Eddie and listening to the experiences of others audits are over-used as training grounds for inexperienced, under trained, and not adequately educated staffers no more than a couple of years out of college.

Worst yet, is the lack of sufficient supervision and oversight their managers and audit partners exercise over them. Many of these managers and partners too suffer from an educational background that did not adequately prepare them to deal with clients such as criminals like I was.

As a result we get “packaged” and “process oriented audits” where a “fill in the blanks” and “check the boxes” approach on audit programs are prevalent. The criminal like I was who always has the initiative and uses a judgment based approach has a fundamental advantage over the external auditors. The external auditors are almost always outmaneuvered by the criminal at every turn.

The external auditors are supposed to be monitored by the Audit Committee of the Board of Directors. In practice such Audit Committees are no better prepared (if not worse) to handle their responsibilities than the external auditors they oversee.

Many Audit Committee members receive compensation in stock options or own company stock of the Board they serve on which provides a disincentive to effective independent oversight and can affect their objectivity and professional skepticism.

In addition, many members of Audit Committees have no formal accounting, auditing, internal control, and fraud education or backgrounds. Their requisite education, skills, training, and experience required to fulfill their responsibilities are lacking.

Over the last week two blogs I read were Jeff Matthews Is Not Making This Up (It Took Apollo Group How Long to Figure This Out?) and footnoted.org (The Political Graveyard?).

Their commentary reinforced to me that the “perfect storm” of convergence of ill trained auditors and “window dressed” Audit Committees is a built in recipe for more massive fraud to come.

In Jeffrey Matthew’s blog when discussing possible stock option back dating he asked:

“So it took the educational geniuses at Apollo Group how long to figure this out and hold somebody accountable?

My detailed answer to Mr. Matthews was contained in a four part post on his site discussing at length the issues outlined above (see my comments to Mr. Matthews post).

In footnoted.org the basic question asked was:

“So where do former members of the House and Senate, not to mention Governors and former Cabinet members go when they exit from the political stage?”
Well, many of these former politician’s end up on company Boards and their Audit Committees.

My short answer to footnotes.org is that I am reminded of what General Douglas MacArthur once said “"old soldiers never die; they just fade away.”

I say we should not let these politician’s fade away on our company Boards especially Audit Committees unless they are fully specifically qualified to serve their functions.

With regards to both blog commentaries I am reminded of the “Peter Principle” that people rise to their level of incompetence.

No doubt that many such Audit Committee members will defend their status saying the have complied with applicable laws.

However I ask you as it is written in The Apollo Group’s 10-k (and many other company 10 – ks too) what level of education, knowledge, training, and skills would you demand of Audit Committee members who job function is:


“…reviewing the financial information which will be provided to shareholders and others, the systems of internal controls, which management and the Board of Directors have established, the performance and selection of independent registered public accounting firm, and our audit and financial reporting processes.”

Would you want Audit Committees composed of members with an accounting, auditing, internal control, and fraud background at the very least? Mere exposure to these issues in their past by such members does not cut it with me.

Under the item 401 (h) of SEC Rule S-K at least one Audit Committee member must be a “financial expert.”

The problem with that rule is that it allows persons who have experience in supervising people more qualified than them for their specific functions to be considered a “financial expert.”

A good CEO without an educational background in accounting, auditing, internal controls, and fraud hardly qualifies to serve on an Audit Committee. Too make matters worse many such persons in Committees have no background in the business the company operates.

From inadequately prepared accountants to inadequately staffed Audit Committees I see here is a “perfect storm” for the future massive financial frauds that surely will occur.

Therefore, anyone reading this post be forewarned – the worse is yet to come!

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