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February 26, 2008

The Auditors are here!

It's that time of year again - the Auditors are here! If you aren't involved with a public company, or a private company that produces audited financial statements, you probably think auditors are people who come from the IRS randomly to make sure you are paying your fair share of keeping the country running. Different kind of auditor. The kind I'm talking about work for big and little accounting companies and they are generally either people just getting into the world of accounting or they are career auditors.  Company's like mine pay them to come in and review the books.

Most companies don't get their financials audited unless they have to, but many years ago I decided that my company would "act like the company we want to become" so we paid to have our financials audited. A misconception is that the auditors are going through the financials with a fine-toothed comb looking for fraud. You'd think that, but no, they are really there just to see if a company is keeping its books in accordance with GAAP (Generally Accepted Accounting Principles) and an ever-increasing library of regulations, guidelines and opinion letters.

I've got probably ten years of experience now with audited financials, and every year I look forward to the "Reps and Warrants" letter to see what new surprises have been tossed in. Given what we pay for this service, you'd think they would be "Representing" and "Warranting" to me, but again no, this is a letter that I'm given to sign by the auditors on behalf of my company. In the early days, it was one or two pages and basically said, "I've given you access to everything you asked for, and as far as I know, we're all doing the best we can to accurately record and report financial transactions, and I'm not aware of anyone trying to steal from the company or cook the books." Ultimately I understood it to mean, "if anything is wrong here, I'm the guy that's ultimately responsible." Clearly not all CEOs see it the same way given some of the bad behavior we've seen, and as a result of these crook's bad behavior, the accounting profession has reacted by creating more, and more, and more rules and regulations.

The problem is, this avalanche of rules and regulations just gives the bad guys more cover to hide behind and makes it even harder for an investor to wade through the volume of reports (I'm talking about public companies now) to figure out what is really going on with their money. I recently read, "The Death of Common Sense: How Law is Suffocating America" written by Philip K. Howard, and except for the frustration I felt, I really got a lot out of the book. To sum it up - more laws and more rules will not make the world or your business a better place. Bad people will always find a way around the bureaucracy and good people will just be frustrated by it and less productive.

My latest Reps and Warrants letter is eight pages long and contains some really interesting paragraphs. I've picked three, just so you get a feel for the tone of the letter. The auditors ask me to warrant that:

All derivative instruments and any embedded derivative instruments that require bifurcation, in accordance with FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities . . .
 
and that . . .

Significant estimates and material concentrations known to management that are required to be disclosed in accordance with the AICPA's Statement of Position 94­6, Disclosure of Certain Significant Risks and Uncertainties.
 
And let's not forget . . .

Violations or possible violations of laws or regulations (including the failure to file reports required by regulatory bodies (e.g., EPA, OCC, FDIC, DOL, Medicare, U.S. Customs Service, HIPAA, IRS, Dept. of Commerce, state and municipal taxing authorities) when the effects of failing to file could be material to the financial statements) whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency.
 
I don't know what a derivative instrument is, except that I think some people got in trouble with them. I wouldn't know where to begin to bifurcate a derivative. While I'm not positive about the AICPA's Statement of Position 946, I also have admit to not being familiar with their positions 1 through 945, and if I would have to guess, there are probably a few more after Position 946 that I may need to review.

The last paragraph that I've submitted for your review is really the catch-all. I think I'm being asked to warrant that any violations, or possible violations of all laws and regulations, including but not limited to those of the EPA, OCC, FDIC, DOL, Medicare, U.S. Customs Service, HIPAA, IRS, Department of Commerce and state municipal taxing authorities, will not effect our financials in a material way. If I read it right, they don't care if there have been violations, they just want to know if the violations will effect our financials in a material way. (For the record, the answer is No.)

I'm not picking on my auditors, or any auditors for that matter because they aren't the ones making up all the new regulations. At their heart, I think they are trying to do a good thing by holding people accountable to a high standard, it's just that I'm not convinced (and neither are they) that much of this is really making companies more transparent. It's really just making it harder for the good people to comply and easier for the bad people to claim they actually did comply or that they misunderstood the rules.

In the end, nothing has really changed for me. If something is wrong, I should have known about it and I'm going to be held accountable for it.  What can we do to keep the world from becoming a quagmire of ineffective laws, regulations and rules?  Don't assume that a new regulation will fix a problem.  Work to fix the problem.  Don't enact a new rule and say, "there, problem solved" because you only get credit if the problem is actually solved.  Focus energy on good people who will do their damnedest to make the right decision, because it is the right decision, and don't tie their hands with bureaucracy that the bad people will just walk right through without a second thought.

February 26, 2008 in Entrepreneurship | Permalink

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Terry Gold has a nice long rant up on his blog titled The Auditors are here! Now, some of my best friends are auditors, but the state, dynamics, and incentives of the accounting industry have gone from bizarre to complete utter madness. As an inv... [Read More]

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Comments

Couldn't agree more with this. The idea that the Sarbanes-Oxely act makes financials more transparent or prevents fraud is humorous. It likely prevents some of the low value fraud, but at a cost probably greater than the loss it's trying to prevent. And the big fraud, the Enron class fraud, well...if the guys with the keys decide to do a 'little late night shopping' in a company...

Posted by: Michael Heukels | Feb 26, 2008 8:06:36 PM

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