Against the background of considerable uncertainty in the financial markets and a deepening economic gloom, there are some very real risks for accountants in the work lying ahead of them.
Recently each month has seemed to bring a new chapter in the unfolding horror story of the European financial market’s investment in mortgage-backed securities, collateralised debt obligations and credit derivatives linked to sub-prime lending in the US mortgage market.
Accompanying this have been the attendant evils of credit crunch, Northern Rock and its ‘outlier’ business model, asset write downs, and the closure or insolvency of a number of hedge funds and structured investment vehicles.
Claims often follow hard on the heels of corporate insolvency. The exercise of judgment on complex issues is always vulnerable to challenge in the light of subsequent developments.
It is obvious, for example, that significant adjustments to valuation opinions over a short-time scale will attract the attention of any stakeholders who have lost out. The sale or refinancing of a hedge fund with a large holding in mortgage-linked structured credit investments rapidly starts to look like a high risk operation for any accountant involved.
This heightened risk environment has been recognised by two Financial Reporting Council publications. The first is intended as a checklist of key factors for audit committees, in particular those in financial institutions that are holding some of the affected investments or have sponsored some of the investment offerings concerned. The second (APB Bulletin 2008/01), summarises guidance on relevant issues for auditors.
The Financial Services Authority has also published a reminder to listed companies about the need for prompt disclosure of price-sensitive information and the desirability of providing information to investors about issues currently under the spotlight such as special purpose vehicles.
The FRC documents highlight the two major risks in terms of financial misstatement: valuation and going concern.
The litigation risks for accountants posed by current circumstances extend beyond audit engagements for financial institutions.
The availability of credit is in a state of flux as lenders continue to tighten up their criteria and lending policies. In the context of transactional reporting, or reporting to lenders for example, the current turbulence in various markets such as in the UK property market, will require considerable care in relation to determining appropriate assumptions and identifying or evaluating sensitivities, since recent past experience may no longer be such a reliable guide.
The challenge
The risk management challenge for all concerned is to be able to demonstrate that sufficient care has been taken to identify and address those risks of financial misstatement that have been heightened by current conditions (for example, provision for bad debts in some of the more badly affected sectors of the economy).
It is of course the directors of companies who are chiefly responsible for the content of the financial statements (including complex investment asset values and debt provision) as well as for the business model being operated by the company.
This legal responsibility for addressing these matters cannot simply be delegated to the auditors, no matter how complex the accounting issues might be.
The FRC has rightly directed part of its guidance at financial institutions. A range of risks (in particular the cost of borrowing and going concern issues) are raised by the credit squeeze affecting SIVs and funds that are dependent on short term finance.
Valuation is clearly one of the key risks that arise in connection with mortgage-backed securities and related CDOs and credit derivatives. The problem is essentially a two-fold one: identifying assets which are impaired or at risk of being impaired, and valuing these assets.
The complexity and illiquidity of these asset types presents some major challenges for their valuation. Some financial institutions (especially end investors such as pension funds and insurers) will require external specialist advice, and may look to accounting firms for this. Any future claimants will be on the look out for auditors and advisers without an adequate grasp of the issues, or who fail to make a robust assessment of the reliability of valuations, or for those who overlook unusual or inconsistent methods and assumptions.
Based on the disputes linked to mortgage-backed securities, CDOs and credit derivatives, valuation of these assets is heavily dependent on information in the hands of third parties and requires specialist expertise using a ‘mark to model’ approach where there is no current market (as will be the case for subprime mortgage-linked securities).
Criticisms made in the past by the Audit Inspection Unit regarding the use of in-house specialists in audit engagements suggest that a major challenge for auditors might be fielding appropriate valuation expertise of their own.
Assessing the reliability of the valuation used by the audit client will also be difficult. Last month there were press reports of Credit Suisse being forced to revise the values of its own asset holdings downwards because of deficiencies in its valuation work. The independence of third party valuations may be an issue due to the affiliation between valuers and the originators of these securities.
The valuation issue catches accountants between the devil and the deep blue sea: under-valuation may be as mortal a sin as over-valuation, causing institutions to engage in undesired capital-raising activities or asset sales, and perhaps pushing them towards insolvency.
If the underlying opinions were at fault, then under-valuation could in some circumstances be a source of claims against firms for even larger losses than over-valuation.
Given market volatility, it is probably no longer a question of whether claims will be made against accountants, but how many.
Economic downturns have historically led to increased claims against accountants and auditors. Very often, the driver for those claims is of course the headline losses which a financially-strained claimant is seeking to recoup, not the quality of the underlying work at all.
That said, whatever the ultimate motive for claimants, the difficult accounting and auditing judgments made in the current environment are likely to be subject to close judicial scrutiny in a court room.
Andrew Howell is a partner and Andrew Forsyth is an associate director in the accountants’ liability team at Barlow Lyde & Gilbert LLP
