Bank regulators discuss auditor performance. (Panel Discussion)
Regulators and CPAs often find themselves at the same financial institution. Are their goals complimentary or opposing? From the regulators' perspective, the best approach is not one of confrontation but of cooperation. A positive working relationship between the two could mean an enormous increase in effectiveness and efficiency for both parties.
Banks and other thrift institutions operate in a highly regulated environment. Regulators at both the Federal and state level are charged with the responsibility of assuring that funds deposited by the public are safe. To carry out their responsibilities, regulators have teams of examiners that visit the premises of banks and thrifts to check compliance with regulations and their financial soundness. In addition, independent public accountants are often engaged to give opinions on the financial statements of those same institutions.
The relationship between examiner and auditor has not always been a smooth one. From the perspective of the independent accountant, the economics of practice do not afford the luxury of detailed and exhaustive reviews of documentation and transactions. The work done for the audit report is based on selective testing, very often with reliance placed on systems of internal control. On the other hand, the regulator, not burdened with the responsibility of an opinion on the financial statements taken as a whole, is able to focus with some intensity on the critical, high-risk areas. Regulators and independent accountants have not always communicated with one another about the results of each other's efforts. In some situations this has created a sense of distrust and second guessing.
Because of the consequences of failed banks and thrifts, independent accountants have begun to realize the regulators' are not the bad guys, that their interests are in common with the regulators, and it is time for improved communications between the two groups.
As a step toward improved communications, the New York State Society of Certified Public Accountants hosted a panel discussion of bank regulators to learn their view of the performance of independent accountants and ways in which communication and cooperation can be improved. The panel comprised a group of CPAs and the following bank regulators: David Baumgaars, Deputy Regional Director, Office of Controller of the Currency; Robert Titillo, CPA, Assistant Director Office of Thrift Supervision; Vincent Conlon, Deputy Superintendent of Banks, State of New York Banking Department, and Nicholas Ketcha, Regional Director and Michael J. Zamorski, Deputy Regional Director, from the Federal Deposit Insurance Corporation. NYSSCPA President Steven Baum, CPA, Executive Director Robert Gray, CPA, and Moderator Steven Sabatini, CPA, all made opening remarks.
The tone of the discussion was set by Robert Gray, who commented that not only do CPAs have an expectation gap with respect to the delivery of services, but so do regulators. In effect, both the CPA and the regulator are in the same boat, but perhaps from a different perspective. Due to gaps in regulation, sometimes it appears that CPAs are not complying with regulations. On the other hand, it also sometimes seems that the regulators are not regulating. A frustration to regulators is the lack of resources to do the job needed to protect the public interest.
What Do The Regulators See?
The regulators on the panel gave their views on the performance of accounting firms. The panelists spoke openly with the hope that their experiences would benefit the profession. All recognized the deficiencies they observed represented a minority of situations in which the independent auditor may not have operated up to expectations. However, it was apparent that the deficiencies were frequent enough to give the regulators serious concern.
During the discussion, patterns in the panelists' observations became evident.
Inadequate Scope of Work
The regulators discussed what they considered insufficient work by auditors in key areas, with the result that auditors were not identifying deficiencies and inadequacies nor recommending meaningful solutions. One regulator cited instances in which banks would receive unqualified opinions from the outside auditors, only to find upon review by his examiners that significant operating problems existed. Somehow the auditors were not identifying the important problems at the institutions. In the minds of the regulators, such situations raise serious questions:
* Are the fee arrangements so limiting that the audit work is superficial?
* Is the work required to give an opinion on the financial standards at such a high level that what is important to regulators is not adequately addressed?
* Does the auditor understand the issues the regulators believe are significant to the public interest and the safety of consumers' deposits?
* Is the financial institution able to direct the independent auditor away from the problem areas so that the independent auditor does not see the problems?
* Is the auditor too willing to accept the answers and reasons given by the bank client for the findings and questions arising during the audit?
The regulator's course of action when finding serious deficiencies in procedures or documentation is to confront management. If the independent accountant is asked why the audit did not reveal those same deficiencies, the common response is that the findings of the regulator were outside the scope of the audit or not the kind of things normally uncovered in an audit of financial statements.
The regulators gave their encouragement to increased interaction between examiner and independent accountant, but expressed their feelings that direct contact happens far too infrequently. They are willing to work more closely with CPAs and to share their findings. The regulator has no authority to seek out the independent accountant. The accountant must seek out the regulator.
Deficiencies in Reporting on Internal Control
Regulators also feel that internal control reporting is another area of deficiency in the outside audit. Examiners will conduct a review of a financial institution and find significant deficiencies in the internal control structure that were not uncovered in the audit nor disclosed in the management letter that accompanies the audit report.
For example, examiners might discover significant foreign exchange trading losses, that although recognized in the financial institution's accounting records, have occurred because of inadequate checks and balances in the internal control system. On paper, the system may have been properly designed, but upon observation by examiners, the system was not properly functioning.
Regulators do not understand why such internal control deficiencies are not being identified in the audit and reported to the appropriate level of management.
The CPAs in attendance expressed their hope that the requirements of the new banking legislation as well as the recently issued COSO report on internal control will lead to more effective reporting on internal control by CPAs.
Lack of Professional Skepticism
A common failing noted by most of the regulators was the absence of an adequate level of professional skepticism when dealing with problem areas. Regulators feel this occurs for a number of reasons: inadequate training, time and budget limitations, a lack of experience, and pressure from management to see their side of the story.
Investment vs. Trading. Regulators pointed to the investment versus trading issue for debt securities as an example of the absence of professional skepticism. Under existing GAAP, debt securities held for investment where the institution has the intention and the ability to hold the securities for the foreseeable future, are carried at amortized cost, even if fair market value is below such carrying amount. A member of the panel stated that he has seen financial institutions engage in what has become known as "cherry picking,"--selling investment securities that have gains while holding investment securities with losses. He feels that some CPAs have not been sufficiently skeptical when reviewing management's position with respect to investment securities that have losses that have unrecognized losses. The regulators said it was difficult to quantify the number of audits of financial institutions where such lack of skepticism exists. They agreed that while it is likely a small percentage, it still remains a significant concern.
This apparent lack of skepticism and perhaps realism has caused the FASB to propose new accounting principles for debt securities as now set forth in the proposed statement of financial accounting standards, Accounting for Certain Investments in Debt and Equity Securities. However, this exposure draft does not entirely eliminate the problem of requiring auditors to act as mind-readers as to the intent of their client's and does not address the problem of "cherry picking."
The Mythical 27 Year-Old Auditor. The regulators discussed what they consider to be the typical staffing in a bank audit. They referred to the mythical 27 year-old auditor trying to challenge senior management with audit findings that might indicate serious operating problems at a financial institution. In such a confrontation, the regulators feel the young auditor, seeking to please both client and senior management of the auditing firm, is no match for the seasoned bank manager who is perhaps fighting for both his or her survival and that of the financial institution.
Regulators stated they are truly free to challenge the managements of institutions to a greater extent that the independent accountant over the positions bank managements may take.
Reality Reigns Supreme. Regulators also observed that auditors sometimes do not seem to recognize significant changes in business conditions. Over the last 18 months, the economy has experienced a significant downturn. One regulator remarked that at some point, auditors should stop believing management's representations that the downturn is just a minor glitch and that prosperity is around the corner. Independent accountants must exercise professional judgement and skepticism to recognize economic realities.
A Typical Meeting Between Auditor and Management in the Eyes of the Regulators. A young auditor identifies a problem in the valuation of a parcel of real estate securing a major loan. She discusses the matter with management and the client says the decline in real estate values in the Arizona desert are temporary. Unconvinced, the young auditor begins to move the issue up the ranks of the CPA firm--first with the audit senior and then the audit manager. Each step also creates time constraints as the promised completion date of the audit approaches. When the issue finally reaches the top, the audit partner discusses the issue with senior bank management, perhaps without the audit staff member present. The bank management rallies its charm and persuasiveness and states unequivocally that the values will come back. The audit partner accepts the bank management's position.
Ivory Tower or the Trenches. The regulators realize the senior members of the profession recognize these very difficult practice problems must be faced realistically with a large measure of skepticism. It has been the regulators' experience that at times engagement partners, as in the earlier scenario, under pressure from their firms' management committees to retain clients, sometimes see the matter from their clients' perspective. Regulators are not sure that the skepticism the profession knows is required is filtering down to the engagement level.
Independence: The Life Blood of the Profession
The regulators expressed their view that long-standing relationships between auditors and clients tend to slowly erode and dilute that key ingredient in the audit process: independence. They also noted that the more significant the relationship between the accounting firm and the institution, the more willing that firm seems to be to stretch and favor the institution's position. Demonstrating a strong belief in these observations, at one point, the Office of Thrift Supervision proposed the mandatory rotation of CPA firms. A bulletin was drafted but was never issued.
No discussion regarding the adequacy of the audit function of financial institutions would be complete without dealing with the review of loan- loss reserves. Regulators take the position that loan-loss reserves must, in the aggregate, cover the exposures that a particular institution faces under current economic conditions. Few would argue with this statement. However, the regulators have observed situations where significant declines in real estate values were not recognized by the financial institution and not identified by the auditor. The auditor did not properly respond to the extent and continuation of the decline in the real estate market. Some regulators questioned whether the auditor was more concerned about the documentation of the loan file than the quality of the loan and its underlying security.
In many cases, as noted earlier, the staff reviewing the loan-loss reserves lacks the experience in the industry and the awareness of the effects of the economy on the loans. Too often, the CPA is concerned with industry percentages or the reconciliation of the loan-loss-reserve account and not the overall adequacy of the reserve.
Senior examiners at the FDIC have developed a loan-loss-reserve worksheet that captures and converts their years of experience in reviewing problem loans into a working document. It is a two step process. The examiner evaluates the loan-loss reserve as established by the institution's management. If the examiner agrees the amounts provided are reasonable and adequate, then nothing more needs to be done. If problems seem to exist, then the working paper leads the examiner through questions and answers to come up with a judgement of the required reserve. This working paper is available and has been shared with CPAs.
The regulators recognize that evaluating loans is a highly judgmental process. When looking at commercial property, more recent information is more important than older information. But in most cases, the problems are not with marginal loans or close calls. The regulators feel the problems are usually more obvious. Effective loan review is a matter of common sense and looking at the situation with professional skepticism.
One regulator especially noted his disappointment in this economic downturn when huge non-performing loans were not properly identified. He felt that the internal review procedures of loans in the audit process did not change even though conditions had significantly worsened.
Adequacy of GAAP
The regulators also addressed whether GAAP had failed to reflect the valuation problems. Was the failure to carry investments at market value the reason losses were not recognized on a timely basis? The regulators felt if the auditors exercised more professional skepticism, the regulators and the public would have been properly served. The regulators also recognized that their own agencies are not without blame.
Certainly the work of the FASB in addressing the carrying value of marketable securities and that of the AICPA Special Committee on Financial Reporting on possible new approaches, will make accounting for very difficult transactions easier in the future.
Documentation and Other Matters
Another problem noted was workpaper documentation. The regulators' reviews of auditor workpapers revealed a significant lack of documentation. When questioned by regulators as to what work was or was not done, the CPA firms always say that the work was done, but it was not documented. The Office of Thrift Supervision also noted some disagreements in judgement with respect to in-substance foreclosures. Apparently, the rebuilding of equity in the foreseeable future is an important consideration. Auditors can often be very optimistic in appraising and evaluating the likelihood of rebuilding equity in the foreseeable future. In the regulator's view, such a period should be very short.
Some of the regulators noted that CPAs sometimes accompany their clients to meetings with examiners and argue and take the position of their clients. The regulators do not see this as the role of the CPA.
The FDIC has seen examples of what it considers to be "opinion shopping" by a financial institution to get the answer it is seeking. Businesses are entitled to seek out answers that make sense relative to their particular circumstances. However, any CPA that gives an opinion on an accounting matter for an entity audited by another CPA is guided by SAS 50, Reports on the Application of Accounting Principles.
Correcting the Situation
The regulators feel CPAs are doing a better job now than they were doing in the past. They do not know the reason for this. Was it because of tougher standards or was it the impact of the civil justice system taking its financial toll?
Both the CPAs and the regulators agreed that it is important the substandard work being done by CPAs be properly identified and reported to the appropriate self-regulatory authorities such as the AICPA and state CPA societies.
The FDIC has instituted a new policy with specific guidelines issued to examiners on how to handle problems in audits. The guidelines would become operational in only the most serious cases. When uncovering a significant problem, the FDIC invites the CPA to the Regional Office to discuss the matter. After discussion with the CPA, if the matter is not resolved, the FDIC refers the matter to the AICPA and the state CPA society. The CPA will be given adequate opportunity to respond to any alleged problems prior to referral to these self-regulators.
All the regulators stressed the importance of CPAs knowing what regulators are doing. They encouraged and almost pleaded that auditors work with them and not against them. One regulator noted a situation where a CPA held the issuance of his report until after the regulators were finished so that the CPA could benefit from the regulators' work. A better way would have been for the CPA to be in touch with the regulators as the examination was proceeding and to issue the report on a timely basis.
Getting While the Getting is Good
The regulators noted that CPAs should recognize when it is time to disassociate themselves from a bad situation. A CPA was involved in a very troubled institution. When challenged by the OTS, lawyers were called in and the OTS spent months trying to unravel and figure out exactly what happened. In the opinion of the regulator, the CPA should have resigned from the engagement when encountering such a troubled institution.
A Tiered Approach
CPAs need to consider the approach the FDIC takes when examining financial institutions; the agency categorizes institutions by tiers. Tier One consists of institutions where regulators, either on the basis of prior experience or other facts, expect to find little or no operating difficulties. The other tiers follow and represent the movement toward institutions with significant problems and deficiencies. In effect, the regulators, not unlike many independent auditors, make a risk assessment of the likelihood of a problem. Regulators perform less work on Tier One institutions than with those in Tier Two, and so on. If problems are encountered with a Tier One institution then the work, of course, is expanded. An independent accountant would not be able to deal with institutions in exactly the same level, because enough work must always be done to give an opinion on the financial statements. However, a lesson can be learned that if problems are encountered, the work must be expanded to fully identify the extent of the losses and other operating and financial problems.
For example, the FDIC has instructed its examiners to look at unusual transactions that occurred near the end of the institution's year or a transaction whose effect is to improve a ratio or other statistics that the institution must maintain.
Joint Solutions to Mutual Problems
Throughout the discussions, it became clear that auditors of financial institutions often do not take advantage of the knowledge and work of bank regulators. Regulators should not be viewed as adversaries. Both regulators and CPAs are concerned about the soundness of the financial institutions and the relevance of the financial reporting. Independent auditors should thoughtfully, within the framework of professional standards, consider and make use of the information available from bank regulators. This means an open dialogue must take place between the regulators, the financial institutions, and the auditors of the financial institutions.
ABOUT THE REGULATORS
David A. Bomgaars has served as District Administrator for the Comptroller of the Currency (OCC), Northeastern district, since 1984. Prior to joining OCC, Mr. Bomgaars was the Acting Deputy Comptroller for Operations in the OCC's Washington, D.C. headquarters. His responsibilities at the OCC include identification of existing and potential conditions of concern and recommendations of appropriate legal and formal administrative actions to promote integrity and stability in national banks.
P. Vincent Conlon holds the position of Deputy Superintended of Banks and Chief Examiner of the Thrifts Institutions Division of the State of New York Banking Department. Mr. Conlon joined the banking department in 1986 and assumed his current responsibilities in May 1989.
Robert J. De Tullio, CPA, is Assistant Director in charge of Special Support for the Northeast Region of the Office of Thrift Supervision (OTS). Mr. De Tullio's duties include providing professional accounting opinions and advice to the examination staff and the industry. Before joining OTS, Mr. De Tullio served as Vice President and District Accountant for the Federal Home Loan Bank of New York. He is a member of both the AICPA and NYSSCPA.
Nicholas J. Ketcha, Jr., joined the FDIC as Regional Director of the Division of Supervision's New York Region in August 1988. Mr. Ketcha served in a number of positions with the FDIC, holding the position of Associate Director of DACS--Financial Services Branch before assuming his current duties. In 1989 he temporarily ran the $4.6 billion University Federal Savings Bank conservatorship in Houston, Texas, as managing agent.
Michael J. Zamorski was appointed Deputy Regional Director for the New York Region in September 1989. At the time of his appointment, Mr. Zamorski held the position of Assistant Regional Director, overseeing the FDIC's bank examination and corporate applications programs for New York State. Previously, Mr. Zamorski served as Assistant Regional Director in the Dallas area and Assistant to the Director of FDIC's Division of Accounting and Corporate Services in the Washington office.
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