The Market Crisis Spawns Accounting And Auditing Issues For Companies

As the market crisis continues to unfold, accounting and auditing issues have emerged as key concerns for companies, their management and their independent auditors. This is apparent from recent statements by the PCAOB and the SEC’s Office of Chief Accountant and comments by SEC Chairman Cox.

Earlier this month, The Public Company Accounting Oversight Board issued a Staff Audit Practice Alert on Audit Considerations in the Current Economic Environment. That Alert focuses on six areas of increased concern in view of the current market conditions. These include fair value measurements, accounting estimates, the adequacy of disclosures and considerations regarding the ability of an enterprise to continue as a going concern. There is little doubt that there will be increased focus on these and other areas in current audits.

Similarly, Marc Panucci, SEC Associate Chief Accountant, Office of the Chief Accountant, raised concerns for management and the auditor in view of the market crisis. In his remarks, Mr. Panucci focused on the impact of current market conditions on a company’s internal control over financial reporting and its disclosure controls and procedures noting: “Current market conditions have resulted in an increase focus on certain areas of financial reporting, such as valuation, impairment, and recoverability of certain assets; fair value measurements … .” These difficult market conditions may have impacted internal controls. In addition, difficult market conditions may create undo pressure to meet financial targets. Therefore “management and the auditor may also need to evaluate whether any changes to the fraud risk assessment are needed.” Remarks before the 2008 AICPA National Conference on Current SEC and PCAOB Developments. Accordingly, management and the audit committee would do well to focus on these areas in reviewing the company’s financial statements.

Finally, SEC Chairman Cox, in a speech before the same group as Mr. Panucci, commented on the SEC’s current study of mark-to-market accounting which has received a significant amount of attention in the current crisis. That study was mandated by the Emergency Economic Stabilization Act passed by Congress earlier this year as discussed here.

In his remarks, Chairman Cox discussed the status of the Commission’s study. Although the final report is not due until January 2, 2009 under the Act, Chairman Cox indicated that its current direction and a number of preliminary findings are in place. In this regard he identified three key points.

First, for many financial institutions, investments marked-to-market are a small portion of their investment portfolio. By far, the largest portion of those portfolios are investments in loans and available for sale securities that are not marked-to-market each period.

Second, most investors agree that fair value is a meaningful and transparent measure of an investment for financial reporting purposes. Financial reporting, the Chairman noted, is “intended to meet the needs of investors. While financial reporting may serve as a starting point for other users, such as prudential regulators, the information content provided to investors should not be compromised to meet the other needs.”

Finally, while accounting standards have served the capital markets well, “we must endeavor to continue to develop robust best practice guidance for auditors and preparers – particularly for fair value measurements of securities traded in inactive or illiquid markets.” The work the Commission has done to date suggests that while mark-to-market accounting improves transparency, better guidance is needed in inactive or illiquid markets according to the Chairman. In view of these remarks it seems clear that the Commission will recommend that mark-to-market accounting continue, but with additional guidance. In the meantime it is clear that management and company auditors will be giving increased scrutiny to accounting and auditing issues keyed to the market conditions.

Unusual Cases: NY Attorney Charged With Criminal And Civil Securities Fraud

Another attorney was charged with both criminal and civil securities fraud. Some commentators have raised questions about what seems to be an increasing trend toward prosecuting attorneys. While there may be legitimate questions regarding some of these cases, based on the pending court papers in the actions filed yesterday, this matter seems more like a TV movie, complete with phony documents, a staged phone call, restitution by the accused when confronted by one victim and ultimately a confession to the authorities.

The accused: The cases were brought against New York Attorney Marc S. Dreier, head of the Drier LLP law firm. The firm has 250 attorneys in offices located in Manhattan, Los Angeles, Stamford, and Pittsburgh. Mr. Dreier was arrested on securities fraud charges in New York following his return from Toronto where he had been arrested earlier this month in connection with another alleged scheme.

The charges: The U.S. Attorney’s Office for the Southern District of New York unsealed a criminal complaint against Mr. Dreier on Monday. That complaint contains one count of securities fraud and one count of wire fraud. At the same time, the SEC filed a civil fraud action against the attorney. SEC v. Dreier, Civil Action No. 08 Civ. 10617 (S.D.N.Y. Filed Dec. 8, 2008).

The allegations: The two complaints detail a multi-million dollar fraud scheme. According to the court documents, Mr. Dreier engaged in a scheme to sell bogus promissory notes supposedly issued by a New York based real estate development company. That company was a former client. Mr. Dreier offered the fraudulent notes to three hedge funds.

First, Mr. Dreier solicited Hedge Fund I. That Fund ultimately purchased two groups of discounted notes, one for $83.6 million and a second for $16.25 million. To induce the Fund to purchase the discounted notes, Mr. Dreier furnished the purchaser with bogus documentation regarding the transaction. He also staged a telephone call, supposedly with the CEO of the issuer. In fact Mr. Dreier had one of his henchmen on the line, not the issuer’s CEO according to the court documents.

Second, Mr. Dreiser solicited Hedge Fund II in an effort to sell more discounted, but bogus notes from the real estate company. The scheme worked again. Fund II paid $13.5 million for the notes.

Third, Mr. Dreiser solicited Hedge Fund III as part of a continuing scheme to sell even more bogus notes. Fund III however, decided to check out Mr. Dreiser. It telephoned the audit partner named in an audit opinion Mr. Dreiser furnished them. The audit partner was real. The opinion was not. The audit partner told Fund III that the opinion was false. When Fund III learned that the audit opinion was false, it refused to go through with the purchase of the notes.

Restitution: Hedge Fund II subsequently learned about the discovery by Fund III. At that point, Fund II demanded that Mr. Drier pay back its money. He did.

The Confession: According to the SEC’s complaint, Mr. Dreier confessed key aspects of the scheme apparently to the authorities including the fact that:

• The notes were fictitious;
• The notes were never issued by the developer;
• He was never authorized by his former client to market the notes;
• He fabricated documents to facilitate the transactions; and
• The financial statements and audit opinions he furnished potential investors were false.

The cases filed by the U.S. Attorney’s Office and the SEC are pending. It is unclear if charges were also filed in Toronto.