Thursday, August 18, 2011

Radio National program on failures of the audit profession

Radio National is the earnest national public radio service in Australia. They recently ran an hour program on the audit profession and this blog and my views particularly on China got a mention.

You can find the program here - and it is worthwhile listening.

Of course if you think that an hour talking about accountants is marginally less interesting that listening to paint dry then you might skip it along with the rest of this post.

Whatever you can find a reasonable review at Francine McKenna's excellent if polemical blog.

I appear after Carson Block just after 41 minutes... I am there as much as anything because I offer a (limited) defense of the auditors which Francine McKenna (who was given the last word) dismisses pretty harshly. The limits were edited out of the show in part because I named certain institutions as corrupt and Radio National did not want to be sued and in part because it was useful for the show to have someone (anyone) on it willing to defend what looks to be indefensible.

Here without the editing is my limited defense of auditors.

Audit is a process which is designed to catch fraud. Any defense that says that audit is not meant to catch fraud is of course nonsense.

The process involves among other things checking that a sample of transactions actually occurred and are accounted for correctly. So you look at individual transactions flowing in-and-out of the bank and check them against bank statements. You check the end balance of key items (receivables, inventory and especially cash).

If an audit is done properly (and that usually involves a competent partner and a group of competent juniors following boring rule-driven process) it will detect almost all major frauds. Competent audit may miss small scale embezzlement but will not miss wholesale fictional accounts.

The bulk of major frauds and almost all of the Chinese frauds would have been detected by proper process.

However now and again you find a really sophisticated fraud which fools that process. In China the main way of fooling the process is to have the bank in the the fraud and have the bank provide accounting statements that match the fraudulent transactions. Of course the criminal firm will also need the customers to be in on the fraud (and say to verify receivables in random checks).

In other words a fraud that fools the process needs to embed itself into a well-controlled fraudulent network. It needs to be elaborate and well constructed.

In that case - and only in that case - I am willing to offer the auditor a free pass. The auditor might have done their job properly and not detected fraud.

I think there are two Chinese frauds that meet this test. The first is China Media Express where I think it entirely possible that Deloitte did their job properly and did not detect the fraud. The other is Longtop (which was also audited by Deloitte). In both cases the customers (advertising agencies and banks) were in on the scam and the banks provided false statements to verify cash flows and cash balances.

And that is the extent of my limited defense of the auditors.



Anonymous said...

I'm willing to take that as a first approximation.
But, as with anything, people should learn from experience (and I still consider auditors people).

That means, if you're auditing Chinese company, expand the process to account for possible external party accomplices, or at least put it in 2" letters right at the top of the audit that you didn't do so and that experience indicates that it may be a crucial part.

Whenever there's a fixed process, a way can be found to circumvent it. That said, that's not an excuse not to incorporate the most damaging/known ways back into the process.

But What do I Know? said...

Wow, fair and balanced commentary. Maybe you could use that slogan; it's not being used anywhere else, is it? :>)

brendan said...


Do you have a textbook rec for an investor that would like to learn more about detecting fraud?

Thanks for running a great blog.


Anonymous said...

"Of course if you think that an hour talking about accountants is marginally less interesting that listening to paint dry then you might skip it along with the rest of this post."

Most people do think accounting is boring and therefore avoid it.

This is why most people shouldn't be in the markets.


Anonymous said...


I'm not sure about your level of accounting experience, but if you are already comfortable with financial statements (for example, if you know how capital expenditure and operting cash flow relate to free cash flow, or you know the dfiference between depreciation and amortization), try Schilit's book (I prefer the second edition to the third edition):

JMO--I'm interested in what John reads too, though...

Josh said...


I'd recommend Quality of Earnings by O'Glove. It will go through checking red flags in accounts receivable & inventory and some past case studies.

What John does is a bit deeper and I haven't found a book that's at his level. John has the unique ability to think deeply about a business, how it works and how it should not work...then able to figure out how the business looks via the financial statements. He then is able to make hypothesis about how the business should work if it is a real company, and see if he can falsify those claims via the accounting.

By the way, I'm just guessing how he does it...but that's how I imagine him doing his analysis.

I think you can't get to that level unless you spend a lot of time thinking about business and accounting in a deep way.


Congrats on the interview. The radio national program has some of the best intro music since Ghostbusters. =P

will said...

100% agree john - the Kingston Cotton Mills case from 1896(!) set out the broad responsibilities of the auditor - still relevant today.

the key quote from below is that "auditors are watchdogs, but not bloodhounds" which i think nicely paraphrases your argument.

somehow i don't think people will be quoting judge judy 100 years from now...

“It is the duty of an auditor to bring to bear on the work he has to perform that skill, care, and caution which a reasonably competent, careful, and cautious auditor would use.

An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion, or with a foregone conclusion that here is something wrong. He is a watchdog, but not a bloodhound.

Auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud, when there is nothing to arouse their suspicion ...So to hold would take the position of an auditor intolerable.”

—Lord Justice Lopes
Regarding Kingston Cotton Mills

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